Tax Issues that May Arise in Divorce and Separation

Tax News You Can Use | For Professional Advisors

Jane Ditelberg, Director of Tax Planning
Katherine Welz Herr, Senior Relationship Advisor

March 10, 2025

Divorce is a complex process and involves careful thought, planning and negotiation. Transfers of assets between former spouses, whether in the form of property divisions, spousal support or child support, are subject to unique tax provisions that apply only in the context of the dissolution of a marriage. In addition, the terms of the decree or settlement agreement can change the tax consequences of certain transfers depending on the wording the parties use. With that in mind, let’s consider some of the most significant tax issues that arise in the context of divorce.

Property Divisions

You may be aware of tax rules that provide that payment of an obligation in kind results in the recognition of gain by the transferor and receipt of income by the transferee. You may also be familiar with the gift tax and its marital deduction. However, there are special rules in the case of a property division due to divorce that prevent the transfer from being a gain recognition event or a taxable gift, so long as the transfer is “related to the cessation of the marriage.” This is, however, only available if both spouses are U.S. citizens, due to the possibility of a non-citizen avoiding future gift, estate or income tax attributable to the asset.

Under section 1041 of the tax code, transfers “incident to divorce” are not subject to income, gift or estate tax. However, in qualifying for this treatment, it is important that the transfer be part of the decree or marital settlement agreement and that the transfer occur within six years. However, even transfers after six years may be a non-taxable event if the former spouses can show that: (1) factors existed that prevented the transfer from occurring within six years, such as legal or business impediments, and (2) the transfer is effected promptly after the impediment to transfer is removed. Understanding whether there is a presumption that a transfer is “related to the cessation of the marriage” is important, particularly in situations where one spouse is making payment to the other in installments. This rule can also apply to payments made by a third party such as where a corporation owned by the couple is directed to make payments in redemption of one spouse’s shares.

Taxation of Alimony

Alimony, more commonly referred to these days as spousal support, received incident to divorce is taxed or excluded from income based on two things: (1) the terms of the decree or settlement, and (2) the date of the decree or settlement. Spousal support payments typically were deductible by the payor and income to the payee. However, parties had the right to provide otherwise in their decree or settlement agreement. This changed in 2017 when the Tax Cuts and Jobs Act (TCJA) was enacted and included specific provisions as it relates to spousal support. While the TCJA is set to sunset in 2025, the spousal support provisions will not.

1. Judgments Entered Prior to January 1, 2019: Despite the passage of the TCJA, alimony paid under a pre-2019 decree or settlement is still deductible by the payor and income to the recipient, unless the parties specify otherwise in a later modification of the judgment. A key element to having a payment treated as alimony and not as another type of payment that does not result in a tax deduction is whether it ends upon the death of the recipient spouse. Payments that could potentially continue after the recipient spouse’s death cannot be treated as alimony and cannot receive the tax advantage of deductibility.
2. Judgments Entered After January 1, 2019: Alimony paid under a post-2019 decree or settlement is not deductible by the payor or income to the recipient.
3. Judgments Entered Prior to January 1, 2019, but Modified after January 1, 2019: Alimony paid under a post-2019 modification of a pre-2019 decree shall remain deductible/income unless the parties explicitly state that the TCJA treatment of alimony payments applies.

Prior to the passage of the TCJA, it was not uncommon for couples to agree to “unallocated support payments,” meaning there was no allocation between spousal support and child support. The decision whether to allocate support payments is no longer relevant for orders entered after January 1, 2019 because spousal support and child support have the same tax treatment. However, for pre-2019 orders, payments that are reduced at the time one or more of the children are emancipated will be assumed to be child support and are not eligible for the deductibility treatment as alimony. In addition, if it is determined that a spousal support payment where the payor received a tax deduction was actually in the nature of child support or even a property settlement, the IRS reserves the right to “recapture” the deduction.

Child Support, Personal Exemptions and Child Tax Credits

Child support payments are not income to the recipient or deductible by the payor. Paying for a child’s support is treated the same way if parents are married or divorced. The tax provisions related to dependent children — currently the child tax credit but potentially, if the TCJA sunsets as scheduled, also the dependent exemption — are generally available only to the custodial parent, assuming the child qualifies as that parent’s dependent. If the parties agree that the noncustodial parent shall be entitled to claim the credit and/or exemption, then the custodial parent must sign a waiver, which the non-custodial parent must attach to their tax return.

In making decisions about who takes the child tax credit or dependent exemption for a child of the marriage, it is vital to look at each parent’s specific income tax profile. Claiming the child as a dependent may benefit one spouse more than the other. This could be because one spouse is in a higher income tax bracket and is no longer eligible for the full credit, because the exemption is more valuable to one of the spouses due to other items on their return, or because one spouse lives in a state with higher income tax rates or has other valuable benefits based on dependent children.

Retirement Benefits

For many families, a sizable portion of their wealth is in the form of retirement benefits. These may include qualified plans offered by an employer or IRAs, including SEP or SIMPLE IRAs. The decree or settlement agreement may call for a portion of one spouse’s retirement account to be transferred to the other spouse as part of dividing the marital assets. Withdrawal of assets from a qualified plan or an IRA generally results in taxable income to the account owner as well as potential penalties if they are younger than age 59 ½. This is why it is important if a couple is dividing retirement accounts in a dissolution that they obtain a Qualified Domestic Relations Order (QDRO) for each account.

If assets are transferred from a qualified plan or IRA belonging to spouse A directly to an IRA (and it must be an IRA) for spouse B pursuant to a QDRO, then no income is realized by spouse A or spouse B upon the transfer. The assets will be treated as spouse B’s IRA subject to the rules on when assets can be withdrawn without penalty and how they are taxed when withdrawn. Regardless of the ages of spouse A and spouse B, IRC § 72(t)(2)(C) provides an exception to the 10% early withdrawal penalty that is normally assessed for individuals under age 59 ½. Specifically, this exception applies if the distributions are made to an alternate payee under a QDRO from a qualified retirement plan, even if the alternate payee is under age 59 ½. Income tax still applies to the distribution unless the funds are rolled over into an IRA.

Other Planning Considerations

Assets transferred as part of a property division carry the same basis as they had in the hands of the original owner. This means that you must look not only at the fair market value of assets being divided but also the potential capital gains tax that would be due upon sale. Parties seeking an equitable division of property should be looking at the after-tax value, although this is not something that is normally taken into consideration by a court if the matter goes to trial, in which case the fair market value is typically used in valuing assets.

Example:

Amy and Bert are getting divorced and are negotiating a marital settlement agreement to divide their assets. They live in an “equitable division of property” state, rather than a community property state. This is their balance sheet:

 

In deciding how to allocate these assets between them, it will be important to consider the built-in income tax consequences associated with each asset. Consider the following:

 

If $2 million of marital assets are allocated to Amy, it matters a lot whether it is the house (subject to a mortgage and with some built-in gain that may be excluded from income), securities (which have a low basis and are subject to capital gains tax at 23.8%) or cash. Amy would not be wise to accept $500,000 in a QDRO from Bert’s 401(k) plan plus $1,000,000 from the securities account to fulfill her share as both of those assets carry significant tax costs.