The Impact of Divorce on Your Tax Returns

A divorce is not only emotionally difficult, but financially difficult. While time may resolve the emotional hurt, the financial difficulties are often complicated and may continue to haunt divorced couples even years after the divorce is final. The Internal Revenue Service is often the cause of ongoing financial stress.

The Internal Revenue Service can pursue either spouse who signs a joint tax return. This means that even though you and your spouse are now divorced, if there are any issues relating to income tax returns you filed jointly while you were married the IRS can pursue you even if you believe the issue was caused by your spouse. During the divorce, it sometimes makes sense to set up a trust fund or escrow account that can be used to settle any tax issues resulting from the marriage that may arise after the divorce.

Hold harmless and financial division agreements are often created by divorcing couples with regard to financial circumstances, but these agreements may not be binding on the IRS. The IRS does not consider whether or not the ex-spouses have created an equitable division of assets during the divorce. Indeed, the IRS is only concerned with obtaining the money it is due. While there is an "innocent spouse" defense, it is extremely difficult to prove and experts note that the IRS seldom accepts this defense.

The transfer of retirement assets is another area the IRS looks at closely. If you and your spouse have 401(k) assets that are divided during the divorce proceeding, the IRS may consider that a taxable distribution and you will be taxed on it. It is important that this distribution be handled carefully. Some financial planning and retirement planning attorneys advise reviewing qualified domestic relations orders (QDROs) with an eye toward federal tax compliance. This is because the IRS often does not consider QDROs when determining what it is owed.

If you and your former spouse will sell your home when you are getting a divorce, you may have capital gains tax impact on you. If you sell while you are still married, you will both be responsible for any gains you made, which may be few in this depressed real estate market. However, if you sell after the divorce, you may qualify for an exclusion of up to $250,000 each.

Particular care should also be taken when determining who will claim children from the marriage on their income taxes after the divorce. It is important that this issue is well settled. It can be an acrimonious issue, because there are many benefits to claiming a child on your tax return, including:

• Putting you into a lower tax bracket by having you be the head of household.
• Claiming the dependent's exemption, which was worth $3,650 per child in 2010.
• Claiming assorted tax credits, which could be worth many thousands of dollars.
• Claiming a deduction for the expenses you spend on that child, including medical and dental bills, as well as education expenses.

Because the ramifications of financial decisions can linger long after a divorce is finalized, it is important that you work with an attorney who is experienced in divorce and financial issues so that there is less likelihood that you will have later financial questions.