What You Need to Know About Divorce and Taxes

Understanding the tax implications of divorce can help you make smarter decisions during settlement negotiations and avoid costly surprises when tax season arrives.

Key Takeaways:

• Divorce affects your taxes in multiple ways, from your filing status to how assets are divided and whether support payments are taxable or deductible.

• The way property is transferred between spouses during divorce generally does not trigger immediate taxes, but the tax basis of those assets matters when you eventually sell them.

• Working with a legal team that understands the intersection of family law and tax considerations can help you protect your financial interests and plan for the future.

When most people think about divorce, they focus on the emotional toll and the immediate practical concerns like where they will live, how custody will work, and how assets will be divided. Taxes rarely top the list of worries, but they probably should. The decisions you make during your divorce can have significant tax consequences that affect your finances for years to come. 

At Kamal Law Firm, PLLC, we believe that informed clients make better decisions. Our team has over 36 years of combined legal experience helping families navigate divorce in Texas, and we understand that the financial details matter just as much as the big-picture issues. We take the time to explain how different settlement options might affect your tax situation so you can move forward with confidence. While we always recommend consulting with a tax professional for specific advice, this overview will help you understand the key tax considerations that come into play during and after divorce.

Your Filing Status Changes

One of the first tax changes you will notice after divorce is your filing status. Your marital status on December 31 of any given year determines your filing status for that entire year. If your divorce is finalized by the last day of the year, you will file as either single or head of household for that tax year, even if you were married for most of the year.

Head of household status offers more favorable tax rates and a higher standard deduction than filing as single, but you must meet certain requirements. Generally, you must be unmarried on the last day of the year, have paid more than half the cost of keeping up your home, and have a qualifying dependent who lived with you for more than half the year. If you have children and will be the primary custodial parent, you may qualify for this status.

If your divorce is not yet final by December 31, you have the option of filing jointly with your spouse or filing as married filing separately. Filing jointly typically results in a lower combined tax bill, but it also means both spouses are jointly liable for any taxes owed. If you have concerns about your spouse's financial honesty or their tax reporting practices, filing separately may be worth considering even if it costs more.

Property Division and Tax Basis

In Texas, community property must be divided in a manner the court considers just and right. When property is transferred between spouses as part of a divorce settlement, the transfer itself is generally not a taxable event. You will not owe income tax simply because you received the house, the retirement account, or the investment portfolio in your divorce.

However, the tax basis of the assets you receive matters a great deal. Tax basis is essentially what you paid for an asset, and it determines how much taxable gain or loss you will have when you eventually sell it. When you receive property in a divorce, you also receive your spouse's tax basis in that property. This is called a carryover basis.

Imagine you receive the family home in your divorce settlement. The home is worth $500,000 today, but you and your spouse originally purchased it for $300,000. Your tax basis in the home is $300,000. If you sell the home later for $500,000, you will have a $200,000 gain that may be subject to capital gains tax, depending on whether you qualify for the home sale exclusion.

Now imagine your spouse receives an investment account worth $500,000 that was funded with $450,000 in contributions. Their tax basis is $450,000, so if they sell those investments for $500,000, they only have a $50,000 gain.

On paper, both assets are worth the same amount. But from a tax perspective, the investment account is more valuable because it comes with a higher basis and therefore less potential tax liability. 

Retirement Account Division

Retirement accounts often represent a significant portion of marital wealth, and dividing them requires special attention to avoid triggering taxes and penalties. When a 401(k) or similar employer-sponsored plan is divided in a divorce, the division must be done through a Qualified Domestic Relations Order, commonly known as a QDRO. A QDRO is a legal document that instructs the plan administrator to transfer a portion of the account to the non-employee spouse.

If the QDRO is properly drafted and executed, the transfer is not considered a taxable distribution. The receiving spouse can roll the funds into their own IRA or retirement account without paying taxes or early withdrawal penalties. However, if you simply withdraw money from a retirement account to give to your spouse without a QDRO, you will likely face income taxes and, if you are under age 59½, a 10 percent early withdrawal penalty.

IRAs are divided differently. They do not require a QDRO, but the transfer must be made pursuant to a divorce decree or separation agreement to qualify for tax-free treatment. The receiving spouse then becomes the owner of their portion and will pay taxes when they eventually take distributions in retirement.

Alimony and Spousal Support

The tax treatment of alimony, also called spousal support or spousal maintenance, changed significantly with the Tax Cuts and Jobs Act of 2017. For divorce agreements executed after December 31, 2018, alimony payments are no longer deductible by the paying spouse and are not considered taxable income for the receiving spouse.

This is a major shift from the old rules, where alimony was deductible for the payer and taxable to the recipient. Under the current rules, there is no tax benefit to structuring payments as alimony rather than property division. This change has affected how divorcing couples negotiate settlements, as the tax advantages that once made alimony attractive to higher-earning spouses no longer exist.

If your divorce was finalized before 2019 and you are paying or receiving alimony under the old rules, those rules still apply unless you modify your agreement and specifically elect to have the new rules apply. Understanding which rules govern your situation is important for accurate tax reporting.

Child Support and Claiming Children as Dependents

Child support is not taxable income for the receiving parent, nor is it deductible by the paying parent. However, the question of who gets to claim children as dependents can have significant tax implications. The parent who claims a child as a dependent may be eligible for the child tax credit, the earned income tax credit, and other tax benefits. Generally, the custodial parent, meaning the parent with whom the child lives for the greater part of the year, has the right to claim the child as a dependent.

However, divorcing parents can agree to allocate the dependency exemption differently. For example, parents might agree to alternate years or to allow the noncustodial parent to claim certain children. If the custodial parent agrees to release the exemption, they must sign IRS Form 8332, which the noncustodial parent attaches to their tax return.

Health Insurance and Medical Expenses

Divorce often means changes to health insurance coverage. If you were covered under your spouse's employer-sponsored plan, you may be able to continue that coverage temporarily under COBRA, but you will be responsible for the full premium cost. Alternatively, you may need to obtain coverage through your own employer, the health insurance marketplace, or another source.

Medical expenses, including health insurance premiums, may be deductible if you itemize deductions and your total medical expenses exceed 7.5 percent of your adjusted gross income. If you are paying significant medical expenses for yourself or your children after divorce, keep careful records in case you are able to claim a deduction.

Trust Kamal Law Firm, PLLC

At Kamal Law Firm, PLLC, we help families across Texas navigate the legal and financial complexities of divorce with compassion and skill. With over 36 years of combined legal experience, our multilingual team speaks English, Spanish, Hindi, and Urdu, ensuring that clients from all backgrounds receive culturally sensitive representation. We handle divorces involving immigration components, offer certified mediation services, and provide strong advocacy for clients facing even the most complicated situations.

We understand that divorce involves much more than legal paperwork. It affects your finances, your family, and your future. Our team is here to help you understand your options, including the tax implications of different settlement choices, so you can make informed decisions and move forward with confidence. Schedule a consultation today to speak with our team about your situation and learn how we can help you protect your interests.