Regardless of where you live, the winter holidays bring about an aura of change. Change of climate, change of year, and and for those who were divorced in the current year, change of status. So don't forget to consider your filing status as you get closer to submitting your taxes as an Unmarried person.
What is Your Filing Status?
My client Judy went to court and obtained a final divorce decree on July 11, 2011. Since she was legally divorced on December 31, she is considered unmarried for the entire year. Judy may file her return as Single, or, if she meets the requirements, Head of Household (HoH). Head of Household status will provide Judy with a higher standard deduction and a lower tax bracket if she had a dependent living with her for more than half the year, and she paid for more than half of the upkeep for her home. Lucky for Judy, her daughter. Jessica, lived with her for the year while she attended school.
Couples who have separated but who are not yet divorced by December 31 have the option of filing their tax return as Married Filing Jointly or Married Filing Separately. You can't file a joint return for the year that your divorce decree becomes final. Your marital status as of December 31 of the year determines your filing status for the entire year.
Who Gets the Dependent Exemption?
You can claim your child as a dependent on your tax return if she lived with you for a longer period of time during the year than with your ex-spouse. However, it is possible for the non custodial parent to claim the exemption for a dependent child if the custodial parent signs a waiver pledging that he or she won't claim it. Read your divorce agreement. This topic is usually handled in the section of the agreement where child support obligations are listed. Being entitled to take the exemption entitles you to other tax benefits, such as the Lifetime Learning Credit and the American Opportunity credit. Please see below.
Jessica lived with Judy through the whole year and Judy paid for all of Jessica's support AND Judy did not sign a waiver to allow for Ed to claim the exemption, Judy is entitled to take the exemption on her tax return.
Can I Take the Tax Credits?
If you claim the dependent exemption, if you qualify, you can also claim the child credit (up to $1,000) and the American Opportunity Tax Credit (up to a maximum of $2,500) or the Lifetime Learning Credits (up to $2,000). But remember: if you can't claim the dependency exemption, you can't claim these credits. In addition, if you are eligible to claim the Lifetime Learning Credit and you are also eligible to claim the American Opportunity Credit for the same student in the same year, you can choose to claim either credit, but not both.
Since Judy is entitled to the dependency exemption for Jessica, Judy can take the child credit and one of the higher education tax credits.
Did You Pay/Receive Alimony?
If you are paying alimony to your ex, you can take a tax deduction for the payments even if you don't itemize your deductions. In order to qualify for the deduction, the payments must be made in cash. Your ex-spouse must include the same amount on his/her tax return and pay income tax on that amount. Beware: if the amount you report differs from the amount your spouse reports, expect to get a call from the IRS. The opposite is true for child support: The payer doesn't get a deduction and the recipient doesn't pay income tax. Be sure to have your ex's social security number on hand. In order to take the deduction you are required to include it on your federal tax return. This allows the IRS to track the payment and ensure that your ex included the income on his/her tax return.
If you are receiving alimony, you must report it on your federal tax return as income and pay income tax. TIP: To make the sting of April 15 less painful, make quarterly estimated tax payments throughout the year. This will not only help you manage your cash flow and prepare a budget but it could keep you from paying costly IRS penalties for failing to pay your taxes. TIP: alimony is considered earned income for purposes of making a tax deductible IRA contribution. Consider contributing to your IRA before April 15 to reduce your income tax liability and save for retirement.
Because Judy and Ed earn a similar amount of income, Judy does not receive, nor does she pay, alimony. Ed pays child support but since that is not included in Judy's income, Judy does not have to include it on her tax return and Ed is not allowed to deduct it from his income.
Did You Sell Your Home in 2011?
If as part of your divorce you and your ex-spouse decide to sell your home, that decision may have capital-gains tax implications. Normally, the law allows you to avoid tax on the first $250,000 of gain on the sale of your primary home if you have owned the home and lived there at least two years out of the last five. Married couples filing jointly can exclude up to $500,000 as long as either one has owned the residence, and both used it as a primary home for at least two out of the last five years.
For sales after a divorce, if those two-year ownership-and-use tests are met, you and your ex-spouse can each exclude up to $250,000 of gain on your individual returns. And sales after a divorce can qualify for a reduced exclusion if the two-year tests haven't been met. The amount of the reduced exclusion depends on the portion of the two-year period the home was owned and used. If, for example, it was one year instead of two, you can each exclude $125,000 of gain.
Judy sold the marital home in November. She and Ed purchased it 13 years ago for $455,000. Due to its prime location and great condition, she was able to sell it for $725,000, which resulted in a capital gain of $270,000. Because she and Ed treated the house as their primary residence for two out of the last five years, the entire capital gain is tax-free.
What happens if you receive the house in the divorce settlement and sell it several years later? Then you can exclude a maximum $250,000 gain. The time your spouse owned the place is added to your period of ownership for purposes of the two-year test.
The holidays can be stressful but dealing with your taxes does not have to be. With the help of a Certified Divorce Financial Planner and a good accountant you can minimize your tax liability and even save for retirement.
Ring in 2012 with confidence, anticipation, independence! The new year could be your year!
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