The splitting of marital assets and the granting of custody each has an effect on taxation of the parties – if astutely planned, ceding assets to the spouse who will be in a lower tax bracket can increase the value of the overall marital estate. In the child custody agreement, the parents must decide which is permitted to claim each child as a dependant for tax purposes.
The modern Internal Revenue Code – the dreaded “TAX LAW” – provides specifically that a transfer of property incident to divorce is not subject to tax consequences. The recipient of the property takes it with a basis equal to the adjusted basis of the transferor. For the uninitiated, this basically means that property appraised at $50,000 is probably less valuable than $50,000 in cash; the property was purchased for some amount, which for our purposes can be considered the basis.* If the purchase price was $20,000, upon sale of the property the recipient will pay taxes on the difference – in this case, the recipient will pay taxes on a gain of $30,000. If the recipient had just taken the $50,000 cash instead, there would be no realized gain and no additional taxation.
Alimony is a special case under the IRC. Essentially, it is treated as income for the party receiving it – as you might expect. In order to avoid double taxation, however, it is deductible from the gross income of the party paying alimony. Since the party receiving alimony is normally going to be in a lower tax bracket, this once again has the benefit of saving a little money at tax time.
The IRC provides that the parent with custody more than 50% of the time can claim the child as a dependant unless the divorce decree specifically provides otherwise or if the custodian parent releases the dependency exemption to the other parent in a written decree. Child support, unlike alimony, is not includible in the recipient’s income and deductible in the transferor’s. The idea behind child support is not a replacement of expected income that was lost in the split, but is the amount of income that would have been spent on the child. Since income is taxed before you buy things for your kids, it is reasonable to require the paying parent to include the amount of child support in his or her gross taxable income.
This is, of course, a very broad and simplified explanation of the tax consequences of alimony and child custody/support and should not be relied upon to make major decisions. Speak to an attorney or tax professional if you are concerned with the effects of your divorce on your income taxes. More information about divorce and other family law issues can be found here.
* This is a very simplified explanation. The basis is not always just the purchase price.