Divorce and Taxes: What You Need to Know About the IRS and Your Financial Future

In a typical divorce case, there generally appear to be three key players: a husband, a wife, and the Internal Revenue Service. There are a number of key areas in a divorce case impacted by tax law, and unless parties are properly counseled about the tax impact of their decisions, in some instances, the impact can be negative.

One of the key areas impacted by tax law is the sale of the marital home. For purposes of assessing capital gains, tax law defines the principal residence as the home where the parties lived for any two of the last five years. If the home being sold is at least one of the parties’ principal residences for two of the past five years when it is sold, each individual is allowed to exclude up to $250,000 of the gain from taxable income if single, and $500,000 as a married couple.

Another area in a divorce case that is impacted by tax law is the area of exemptions for the children of the marriage. Among the many disagreements between divorcing couples, one fight among couples with children is the fight about who is entitled to the tax exemption in a given year. Generally, the IRS assumes that the spouse who has custody of the children is entitled to the exemptions. Of course, parents are allowed to trade the exemptions back and forth freely using IRS Form 8332. Parents with multiple children have the option to split the exemptions; however, parents often fall into this pitfall, and what appears to be a fair split, at times, prevents parties from maximizing their tax savings. The best approach as it relates to exemptions,s is to consult an attorney who can calculate the value of the exemptions so that both parties’ tax savings are maximized each year.

Another key area pertains to the tax filing status. Tax filing status is determined by the parties’ status on December 31st of each year. If divorced or legally separated as of December 31, the parties file as single taxpayers for that year. However, if still married as of December 31, parties who lived in the same household must file as married. Another tax filing status is head of household. If you are unmarried, you can qualify to file as head of household if, for more than six months of the tax year, you paid more than one-half of the cost of maintaining a home for yourself and a qualifying person. On the other hand, if you are married, you can qualify to file as head of household if you pass the qualifying test, which, among some steps includes you having paid for more than one half of the cost of maintaining a home for yourself and a qualifying person and your spouse can not have lived with you for the last six months of the tax year. As head of household, you’re entitled to more generous tax brackets and a bigger standard deduction.

So, if you’re separating, divorcing, or contemplating either of the two, you should strongly consider consulting with an attorney who will assist you in assessing the potential tax consequences of your decisions so that you can safely maximize your tax savings each year.

Additional Key Tax Factors to Consider During Divorce

Alimony and Tax Deductibility After the TCJA

Under the Tax Cuts and Jobs Act (TCJA) of 2017, alimony payments are no longer tax-deductible for the payer, and the recipient no longer includes them as taxable income for divorce agreements executed after January 1, 2019. This major change affects how divorcing spouses negotiate settlements and calculate post-divorce budgets.

Child Support: Not Taxable, Not Deductible

Unlike alimony, child support is neither tax-deductible by the payer nor taxable to the recipient. It’s important to distinguish between the two when drafting or reviewing a divorce decree to ensure the tax treatment is clearly understood.

Retirement Accounts and QDROs

Dividing retirement accounts such as 401(k)s or pensions requires a Qualified Domestic Relations Order (QDRO). A QDRO allows funds to be transferred from one spouse to another without triggering taxes or penalties at the time of transfer, though the recipient will owe taxes on distributions when withdrawn later.

Dependency and Child Tax Credits

While the exemption rule largely dictates which parent can claim a child, Child Tax Credit eligibility also comes into play. The IRS typically allows the custodial parent to claim these credits unless otherwise assigned through IRS Form 8332. It’s crucial to also consider related credits such as the Earned Income Tax Credit (EITC), Child and Dependent Care Credit, and education-related credits, which may be affected depending on adjusted gross income (AGI) and household status.

Adjusted Gross Income (AGI) and Phase-Out Effects

Claiming or not claiming a dependent child can alter your AGI, which in turn affects eligibility for several valuable tax benefits. Phase-outs tied to AGI may reduce or eliminate eligibility for certain credits. Spouses going through divorce should have a tax expert calculate various scenarios to determine optimal tax outcomes under both joint and individual filings.

Property Transfers Between Spouses

One often overlooked area is the transfer of property during or after divorce. According to IRC §1041, transfers of property between spouses incident to divorce are not subject to federal income tax. However, it’s essential to track basis and holding period because they transfer along with the property, potentially affecting future capital gains.

Innocent Spouse Relief and Audit Risk

Divorced individuals may find themselves liable for tax understatements made by their former spouse. The IRS offers Innocent Spouse Relief for taxpayers who meet certain conditions. This is especially relevant for joint filers who later uncover errors, fraud, or hidden income. Divorced spouses should be proactive in separating tax liability or seeking relief options early.

Withholding and Estimated Tax Payments Post-Divorce

Divorce changes your household income and deductions, which can result in overpayment or underpayment of taxes. It’s critical to update your W-4 form as soon as your filing status or income changes. In some cases, switching to quarterly estimated tax payments may be necessary to avoid underpayment penalties, especially for self-employed individuals or those receiving irregular support payments.

IRS Form 2120: Multiple Support Declaration

In cases where a child or dependent is supported by multiple individuals, such as grandparents or step-parents, Form 2120 may be filed to allocate the exemption. This situation arises most often when the child lives across multiple households post-divorce, and coordinated tax planning becomes essential.

Filing Status Explained in Depth

Married Filing Jointly vs. Separately

If still married on December 31, couples can choose to file jointly or separately. Filing jointly often results in lower tax liability due to broader income brackets and more generous deductions. However, it also means shared liability for any taxes owed or underreported. Filing separately may be preferred if one party expects substantial deductions, has legal concerns, or wishes to limit audit exposure.

Head of Household Requirements

To file as head of household, a taxpayer must meet three criteria: be considered unmarried on the last day of the year, have paid more than half the cost of maintaining a home, and have a qualifying person (such as a dependent child) living in that home for more than half the year. This filing status offers reduced tax rates and a higher standard deduction than the single filing status, which can be especially advantageous post-divorce.

Common Divorce Tax Mistakes to Avoid

One of the most common misconceptions is assuming that alimony remains tax-deductible, which is no longer true for agreements finalized after 2018. Another critical error is failing to update your W-4 withholding after separation, potentially resulting in a tax bill or penalty at year-end.

Parents often misunderstand the rules around dependency exemptions and child tax credits, particularly when attempting to alternate years or split exemptions. This can lead to audit triggers or loss of eligibility for valuable credits. Selling the marital home without planning for exclusion thresholds can also result in capital gains taxes that might have been avoided. Lastly, many overlook the need for a QDRO when dividing retirement accounts, which can cause unintended taxes and penalties if not executed properly.

Frequently Asked Questions (FAQs)

Who can claim the child tax credit after divorce?

Generally, the custodial parent can claim the child tax credit unless the non-custodial parent is assigned this right using IRS Form 8332.

Is alimony taxable income?

For divorces finalized after January 1, 2019, alimony is not taxable to the recipient and not deductible by the payer.

What happens if we both claim the same child on our taxes?

The IRS will apply tie-breaker rules that generally favor the custodial parent, but it could trigger audits and delays for both parties.

Do I need a QDRO for dividing my spouse’s 401(k)?

Yes. A QDRO is necessary to legally and tax-efficiently divide retirement plans like 401(k)s or pensions.

What if I sold my house after divorce, do I still get the capital gains exclusion?

You may qualify for the exclusion if the home was your principal residence for two of the five years before the sale, even after divorce. Consult a tax attorney.

Can we split the child exemptions between parents?

Yes, but it’s complex. A tax professional or attorney should review to avoid phase-out penalties and optimize deductions.

What IRS forms do I need to file after a divorce?

You may need IRS Form 8332 for exemption transfer, Form 2120 in multiple support cases, and possibly Form 8857 (Innocent Spouse Relief) or Form 1040 with revised filing status.

How does divorce affect my eligibility for tax credits?

Divorce can change your AGI and filing status, impacting your eligibility for credits such as EITC, education credits, and the Child and Dependent Care Credit.

Final Thoughts: Why Tax Planning is Essential in Divorce

Tax implications are one of the most commonly overlooked aspects of divorce, but they can dramatically affect both parties’ financial futures. With new laws, evolving IRS interpretations, and multiple factors at play, strategic tax planning must be part of every divorce settlement discussion.

Consulting a legal professional who understands the nuances of tax law, IRS forms, and financial structuring is critical not just for compliance, but for safeguarding your post-divorce stability. Each decision made during divorce proceedings, from who claims a child, to when to sell the house, to how retirement is divided, carries financial consequences that compound over time.

Speak to a Divorce Attorney Who Understands Taxes

At Reape Rickett, we help you make informed legal decisions while safeguarding your financial future. From dependency claims and QDROs to property tax strategies and audit protection, our attorneys offer personalized support for every situation.

Schedule your confidential consultation today to ensure you’re making tax-smart decisions during this critical life transition.