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Dividing Property In Divorce Tax Traps – Part 5



Dividing Property In Divorce Tax Traps - Part 5

(Part 5 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In A Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)  

Example: Rob Sr. and Mary are divorced. Mary and their son Rob Jr. continue to live in the former marital residence while Rob Sr. lives across town in an apartment. Rob Sr. pays the mortgage payment on the home.

Since Rob Sr. no longer uses the home as his principal residence, he cannot deduct the mortgage interest attributed to the payments under the principal residence mortgage interest rules. However, since Rob Jr. lives in the home, Rob Sr. can deduct the mortgage interest (assuming it otherwise qualifies) under the rules that allow mortgage interest for a second home to be deductible by a nonresident spouse when a direct family member continues to live in the residence.

  • Post marriage payments for home mortgage interest. If the former marital home is not sold during the divorce proceedings, what generally happens is that one spouse will continue to use the home as his/her principal residence and the other former spouse will make other living arrangements. Often, the former spouse not living in the former marital residence will continue to pay some or all of the expenses for keeping up the home, including the mortgage.
  1. Payments may qualify as alimony. When one ex-spouse owns and lives in the former marital home, and the other ex-spouse is required under the terms of a pre-2019 divorce or written separation agreement to pay the cost of maintaining the house, such payments may be considered alimony and therefore be deductible by the payer and taxable to the recipient. The payments would have to meet all the requirements for deductible alimony.[1]
  2. ii) Residence owned by both former spouses. When joint ownership of the residence is maintained post marriage, the expenses paid by one former spouse will benefit both former spouses. Assuming the payments otherwise meet all the criteria to qualify as pre-2019 alimony, one half of the payment could be allocated to alimony. The other half of the payment would be allocated to the maintaining of the property. Example: Fred and Wilma are divorced on December 1, 2018 but continue to jointly (as tenants in common) own their home. Wilma occupies the home as her principal residence. The divorce decree orders Fred to pay Wilma $5,000 a month in alimony. The divorce decree further orders Wilma to pay $2500 per month for the mortgage payment. Half of this amount ($1250) can be allocated to Wilma as taxable alimony income and will be deductible by Fred. Since the other half is going toward a payment for which Fred has an equity interest, it is neither taxable to Wilma nor deductible to Fred.[2] Therefore, the actual amount of alimony that is taxable to Wilma and deductible by Fred is $3750.

Calculated as follows:
Gross Alimony Ordered                                              $5,000

Less portion to Fred’s Beneficial Equity Interest          <$1,250>

Net Alimony                                                               $3,750

iii) Residence owned by only one former spouse. If the residence is owned and occupied by one former spouse and the nonresident spouse is making the mortgage payments, such payments can be considered alimony for a pre-2019 divorce assuming they otherwise qualify.

  • Payments must be made under terms of divorce or separation agreement, or by written request of the payee spouse.[3]
  • Written requests must state that the payment is intended as [4]
  • Written requests must be received by payor prior to the filing of his/her tax return for the year in which the payment occurs.[5]
  1. Retirement Plans/IRAs

Editor’s Note: Due to the Covid-19 pandemic, the Coronavirus Aid Relief, and Economic Security Act (CARES Act) was passed by Congress and signed into law by the President.  The CARES Act significantly changed the rules for retirement distributions and contributions that took place in 2020.  A detailed discussion of the CARES Act is beyond the scope of this material, however as it pertains to Coronavirus-related distributions that took place in 2020, the reader is advised to consult other appropriate source material including but not limited to IRS Notice 20-50.

With the possible exception of the jointly owned marital home, a couple’s single largest asset is often the retirement plan of one or both spouses. Such plans may take the form of a “Qualified plan” as in the case of a Defined Benefit Plan, or they may be “unqualified” as is the case with an IRA. The tax treatment in divorce between the two types of plans is vastly different and extreme care should be taken in dividing and distributing both types of plans so as to avoid an inadvertent tax disaster.

  1. QDRO (Qualified Domestic Relations Order) must be used if tax is to be avoided on splitting qualified retirement plan in divorce

a)  With QDRO in place distributions are taxed to the spouse who receives them.[6]

  1. b) Without QDRO in place, distributions are taxed to the plan participant regardless of who receives them.[7]

Tax Trap Alert: It is critical that a QDRO be in place to affect the tax-free division of a qualified retirement plan in a divorce situation. Otherwise the plan participant spouse risks a tax disaster wherein he/she is taxed on the funds distributed to the former nonparticipating spouse. Participating spouses are thus potentially stuck with the worst of both worlds in the form of being taxed on money never received.

  1. c) Qualified Retirement Plans that distribute participant’s benefits to another person without a QDRO in place risk disqualification.[8]
  2. d) Designation of surviving spouse is critical.

Tax Trap Alert: Often a QDRO will split a retirement plan with part going to the non-participant spouse and the remainder staying with the participating spouse. It is important that the participating spouse remember to re-designate the surviving beneficiary, assuming the participating spouse does not want the nonparticipating former spouse as the alternate payee in the event of the participating spouse’s death.

Example: Rob and Mary divorce and one of half of Rob’s qualified retirement plan is ordered paid to Mary under the terms of a QDRO. Prior to their divorce, Mary was listed as the surviving beneficiary in the event of Rob’s death. Pursuant to the QDRO one half of the plans assets are transferred to Mary, however Rob never changes the surviving beneficiary for his remaining half of the plan’s assets to someone other than Mary. Years later Rob remarries and then promptly dies. Under the ERISA rules, the assets remaining in Rob’s plan would be payable to Mary since she is the designated alternate payee.  Although Rob’s widow may be able to obtain some relief in State court, the proper designation of her as the surviving beneficiary in the first place would have prevented the problem.

Go To Part 1 In Series

Go To Part 2 In Series

Go To Part 3 In Series

Go To Part 4 In Series

Have a question? Contact David Ellis, Ellis & Ellis CPAs.

All Tax Practitioners And Taxpayers Welcome To Contact Me

(All footnotes will be posted at end of series! This material is for informational purposes only and is not a substitute for tax advice from a qualified professional and the author assumes no liability whatsoever in connection with its use.  No advisor/client relationship exists.)

David Ellis is the managing partner of Ellis & Ellis, CPAs, Inc. located in Pasadena, California. He has over 25 years of experience in the practice of Divorce, Trust/Estate, and other family tax matters. He is an advisor in matters pertaining to Trust, Estate, and Corporate Taxation to the Los Angeles County Office of the Public Guardian. The firm also provides other general tax services and IRS representation. He earned his Bachelor’s Degree from the University of Southern California in Communication Arts and Sciences. He is a frequent writer and speaker on various tax subjects, and has provided continuing education services to other CPAs and tax professional in the area of Divorce, Trust, and Estate Taxation. An article that he recently co-authored entitled The Tax Consequences of Dividing Marital Property can be found in the December 2014 issue of Practical Tax Strategies, a national professional tax publication.

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