If you are divorcing, you should consider the opportunities now made possible by the Taxpayer Relief Act of 1997. Although there are many changes, those most likely to affect divorcing individuals and their families deal with the following areas:
It is easier to get money from IRA’s to pay alimony and support.
Because of reduced capital gains tax rates, low basis property becomes more valuable.
The dependency exemption is more valuable.
A new exclusion for capital gains makes the sale of the marital home after May 6, 1997 easier and more valuable.
WITHDRAWING MONEY FROM IRA’s
Until December 31, 1996, if you took too much of a withdrawal from an IRA, you would have been subject to a 15% excise tax. As to withdrawals made after December 31st, 1996, this rule has been repealed – meaning that at divorce, IRA’s may be a source of funds to consider when it comes to paying support and funding property division deals.
CAPITAL GAINS TAX RATES
Although the new law includes some complicated changes to both tax rates and holding periods, most importantly, the tax rates for capital gains have been lowered significantly concerning property that has been held for more than 18 months where the rate has been lowered from 28% to 20%.
This means that (1) properties distributed at divorce with low tax basis are more valuable because the taxes have been reduced and (2) it will be less costly to sell low basis property to make alimony and support payments when necessary.
DEPENDENCY EXEMPTIONS ARE MORE VALUABLE
In the past, the dependency exemption oftentimes was not worth fighting over; however, the changes in the tax law have stepped up the value of the dependency exemption in certain circumstances.
Beginning in 1998, parents can receive a yearly tax credit for each child under age 17 ($400 per child for 1998 and $500 per child thereafter). In addition, parents can take advantage of new educational expense credits which may result in thousands dollars for each child who attends college or graduate school. But there is a catch: divorcing parents can utilize these generous tax credits if -- and only if – the parent is entitled to the "dependency exemption."
This creates real potential value in the dependency exemption. For example, a six year old child will entitle the parent to 12 years at $500 credits ($6,000) in addition to possible education credits. And if there are two or three children, the value is even more attractive.
In the past, folks who divorced sometimes agreed to transfer the exemption from the custodial spouse -- who is entitled to the exemption -- to the non-custodial spouse -- who has the higher tax bracket so he or she could take advantage of greater tax savings. But this should not be done if the non-custodial spouse’s income is high enough to cause a phase out of the exemption. And, to complicate matters further, the new credits phase out at lower income levels than does the exemption.
This means that a parent’s total tax may be less if the exemption remains with the custodial -- or lower tax bracket -- parent under certain circumstances. That’s why, if the custodial parent with a lower tax bracket wants the dependency exemption for one or more children, it might be possible to negotiate reduced alimony payments to her. For these reasons, calculations should be made on a case-by-case basis.
And there is yet another benefit that makes the dependency exemption more valuable: The ability to deduct interest on loans taken out to pay for a child's educational expenses that comes due and is paid after 1997. In order to qualify for this deduction, the taxpayer must claim the child as a dependent in the year in which the loan was taken out.
How much interest can be deducted? In 1998, the maximum is $1,000; in 1999, $1,500; in 2000, $2,000; and $2,500 per year thereafter. But Remember: You can only deduct interest that is paid during the first 60 months in which interest payments are required to be paid on the loan.
Adjusted Gross Income Phaseouts: These deductions phase out at the following levels: Joint filers, between $60,000 and $75,000; All other filers, between $40,000 and $55,000. After the year 2002, these amounts will be adjusted for inflation.
NEW TAX CREDITS
The $500-per-child credit
This credit is available for the direct descendent, stepchild or foster child. Phase Outs depend on filing status and adjusted gross income as follows:
Joint Returns, $110,000; Single Returns and Heads of Household, $75,000; Married Filing Separately, $55,000. When these levels are exceeded, the total credit for all dependent children is reduced by $50 for each $1,000 of income or part thereof.
There will be no adjustment for inflation as to the amount of the credit or the phase-out amounts. For those who don’t owe taxes against which the credit can be applied, they may qualify for a payment from the government in place of the credit if they have three or more children based on a complex formula.
The Hope Scholarship Credit
Maximum – $3,000 per Child
This credit is available for up to $1,500 per child per year of tuition and related educational expenses incurred during the first two academic years of post-high school education. The credit is determined each year as follows: 100% of the first $1,000 of tuition and educational fees, and 50% of the next $1,000 for a maximum of two years. The credit applies to expense paid after 1997.
This credit phases out at adjusted gross income levels between $80,000 and $100,000 for joint filers, and between $40,000 and $50,000 for others. Both the amounts of the credit and the phase-out figures will begin to be adjusted for inflation in 2001.
This credit can not be used for a child in a year in which any part of the child's education expenses were paid with tax-free distributions from an "Education IRA" which was created by the new tax law.
The Lifetime Learning Credit
Used for tuition and related expenses in regard to undergraduate and graduate education and job training courses, this credit differs from the Hope Scholarship Credit which is calculated on a "per child" basis. This credit is the maximum amount that can be taken each year for all children combined.
Beginning with educational expenses beginning and paid after June 30, 1998, until the year 2002, the credit will be equal to 20% of up to $5,000 of educational expenses – a maximum credit per year for all children of $1,000.
Beginning in 2002, the credit will be calculated at 20% of up to $10,000 of educational expenses – a maximum credit per year for all children of $2,000.
The credit phase-out schedule for this credit follows that of the Hope Scholarship Credit: Between $80,000 and $100,000 for joint filers, and between $40,000 and $50,000 for others. Both the amounts of the credit and the phase-out figures will begin to be adjusted for inflation in 2001.
Like the Hope Credit, this credit can not be used for a child in a year in which any part of the child's education expenses were paid with tax-free distributions from an "Education IRA" which was created by the new tax law.
HOME SALE EXCLUDED FROM CAPITAL GAINS TAXES
Before May 6, 1997, in order to avoid capital gains taxes on "principal residences," the selling spouse (or spouses) were required to roll over their gain into a new home (or homes) in order to avoid capital gains taxes. But if one spouse moved out of the home before the sale and the home was no longer considered to be his or her "principal residence," that spouse would not be able to qualify for the rollover and would be taxed on the gain.
For those 55 or older at the time of the sale, a one-time $125,000 exclusion from capital gains was available; however, because it was a "one-time" benefit, many difficulties arose, especially with second marriages where the new spouse also owned a home.
Since both of these complex provisions were repealed by the new law, the home has become a much more valuable asset because each spouse involved in the divorce will be able to exclude up to $250,000 of gain from the sale of the marital home from taxation.
To make matters even simpler, the home need not be a spouse's "principal residence" at the time of the sale -- just during two out of five years before the sale. And if one spouse moved out while the other continued to use the residence as his or her "principal residence" according to the terms of a divorce decree or separation agreement, the spouse who moved out will be able to "count" this time and still qualify.
And instead of the one-time "55 or over" exclusion during a lifetime, the new law allows a larger exclusion with no age requirement that can be used every two years, not just once in a lifetime.
In order to qualify for the exclusion, the following conditions must be met:
(1) the spouse taking the exclusion must have owned the home and used it as his or her principal residence for two out of five years before the sale, and
(2) the spouse who takes the exclusion can not have used the exclusion during the two years before the sale.
This means that if husband moves out of the family home and the divorce order allows wife will stay there for three years before the home is sold and the proceeds divided, husband will be treated just as though he had been living in the home during the three year period and will be able to use the exclusion.
But the period of time between the date the spouse moved out and the date on which the agreement or decree becomes effective does not count. In other words, should one spouse move out of the home for more than three years, in order to allow that spouse to qualify for the "two-of-five-years requirement," the agreement or court order must provide that the remaining spouse stays in the home for at least two more years.
What if the home is owned by one spouse and is sold prior to the divorce? So long as the couple files joint tax returns for the year of the sale, they can exclude up to $500,000 -- even though the home was owned by just one of them.
What if one spouse owned the home during the marriage and transferred the residence to the other as part of the divorce? The recipient spouse will be allowed to use the $250,000 exclusion even if the home is sold less than two years later because the former spouse's time of ownership "counts" for purposes of the two-out-of-five-years requirement.
What happens if one spouse uses the exclusion and then remarries? Under the new law, the new second spouse will still be eligible for the exclusion and can use it less than two years later. This is a change from the former "55 or over" exclusion which would not allow the new second spouse to be able to use the exclusion during the marriage.
What about vacation homes? The new rule that allows the spouse who moves to "count" the time the other spouse stays in the home applies not only to the marital home, but also to vacation homes or new homes so long as the decree or agreement provides for a spouse to live in a vacation home or new home that the spouses jointly own. In this event, both spouses can later exclude gain on the sale.
This is a basic outline of the new tax law and is not intended to be construed as either legal advice or tax advice. Because all situations are different, make sure to contact your tax advisor before making any decisions or taking any action.
© 1997, Flying Solo