If I receive a cash settlement from my divorce, do I need to report the money I received as income on my U.S. Income Tax Return?
It depends on how the funds are classified in the divorce or legal separation documents. An award of spousal support or spousal maintenance (i.e. alimony) is taxable income to the individual who receives the support pursuant to I.R.C section 71(a). Thus, the person who is paying the support receives a tax deduction under I.R.C section 215. To qualify as spousal maintenance all of the following requirements must be met, (1) the payment must be in cash or its equivalent; (2) the payment must be received by or on behalf of a spouse or former spouse under a court order; (3) the court order must not specifically state that the income is not included as gross income or not allowed as deduction; (4) the individual receiving the support must not reside in the same household as the person paying the support; (5) there is no requirement for the payments to continue after the death of the party who is receiving the support; and (6) the person paying the support and the individual receiving the support must not file a joint tax return for the year in which the support is paid.
A property settlement award or transfer of property between spouses incident to a divorce, however, is not subject to taxation under I.R.C section 1041. It may be beneficial for the parties to reach an agreement that does not divide all of the assets, but instead awards one of the parties a lump sum settlement for their equity interest in the marital property. For example, the parties may have a home worth $300,000.00 that is encumbered by a $100,000.00 mortgage. Instead of selling the home, incurring realtor fees, and then dividing the remaining proceeds from the sale, an agreement could be reached that awards the home to one spouse. In exchange, the individual awarded the home agrees to pay the other party $100,000.00 as a property settlement. Under this scenario, no taxable gain or loss is recognized on the transfer of the $100,000.00 property settlement pursuant to I.R.C section 1041.
Both family law practitioners and clients should be aware of spousal maintenance awards that are disguised as property settlement awards. The Internal Revenue Service has additional rules that prevent property settlement payments from qualifying for the tax benefits available to spousal support payments. For example, if the divorce or legal separation document states that the Husband will pay the Wife a large sum of spousal support in the first year, and then substantially less support in the years to follow, the IRS has a formula known as the “recapture rule" that may require the individual paying the support to recapture some of the money paid in year one as taxable income. The recapture rules are set for in I.R.C section 71(f).
What are the tax implications if my spouse and I agree to sell our residence or the court orders us to sell our home during our divorce proceedings?
I.R.C section 121(b) provides that an individual may exclude from income up to $250,000.00 of gain ($500,000.00 if sold as husband and wife on a joint return) that is realized from the sale of a primary residence provided the Internal Revenue Service’s ownership and use tests are satisfied. As a general rule the gain will only be exempt from tax if the home was used as primary residence for an aggregate of two years over the past five years. So unless your home has increased $250,000.00 in value from the date you purchased it (or $500,000.00 if purchased with your spouse), there will be no taxable gain on the sale of personal residence.
In a situation where the home has increased in value, the issue will turn to whether or not the taxpayer primarily resided in the home for a total of two years during the five year period preceding the date of sale. Any temporary periods of absence of less than an entire year would count as periods of use (e.g. vacation, work travel, or seasonal absences). In the event of a temporary court order or restraining order that was entered while the divorce or legal separation was pending, I.R.C section 121(d)(3)(B) states that “an individual shall be treated as using property as such individual’s principal residence during any period of ownership while such individual’s spouse or former spouse is granted use of the property under a divorce or separation instrument." A special exception to the two-out-of-five rules exists for active duty military personnel under I.R.C section 121(d)(9).
If any portion of the gain of a primary residence is associated with a separate dwelling unit, the dwelling unit is subject to allocation and taxation. You will need to discuss the allocation issues with your accountant. The dwelling unit will not be lumped in with the primary residence. The IRS Regulations are clear on the allocation requirements for mixed use property.