What does it mean to allocate income and deductions?
One of the goals of divorce proceedings is to divide marital property between the spouses. Along with the division of assets and the assignment of debt, issues involving the allocation of income and expenses (deductions) must be resolved as well. For example, division of interest and dividends on jointly held assets must be discussed, as should the deduction for real estate taxes paid. And allocations of tax carryovers--although sometimes overlooked--are an especially important tax issue related to divorce. Carryovers frequently take the form of losses that could not be used (deducted) in a given tax year and are available for use in future years.
To aid parties and their attorneys to uncover all items of income, debt, expenses, and assets, it's necessary for each spouse to complete a financial affidavit and to participate in the discovery process. A thorough understanding of the rules regarding the division of debt is also helpful to divorcing spouses.
What filing status should a divorcing couple select?
Your selection of a filing status for a given year will depend on your marital status as of the last day of the tax year (December 31). If you're still legally married as of the last day of the year, you and your spouse can choose to file a joint return together, if certain conditions are met. However, many attorneys advise their clients to file married filing separately in order to avoid liability for a spouse's taxes and/or possible penalties. If you choose to file married filing separately, or if you're drafting a property settlement agreement, you need to consider how to allocate income and expenses.
For more information about filing status as it relates to separation or divorce, see Filing Status Considerations.
When do you allocate income and expenses?
Allocations of tax items are often made retroactive to the date of separation. For example, if a couple owns a piece of property jointly, the income and expenses pertaining to the property (including depreciation, depletion, and amortization) could be allocated 50/50 to each spouse after the date of separation. However, state law (or agreement between the parties) will determine the actual allocation date.
Are allocations affected by whether you live in an equitable division state or a community property state?
The rules governing the reporting of income and deductions differ significantly between equitable division states and community property states. For definition of equitable division states and community property states, see Property Settlement.
Equitable division states
The majority of states are equitable division states. In these states, dividing income between divorcing spouses is relatively straightforward. The general rules are as follows:
- Earned income is taxable to the spouse who earns it (e.g., wages or salary).
- Income from property is taxable to the property's owner (state law determines the nature of ownership rights).
- When property is owned as joint tenants, tenancy by the entirety, or 50 percent tenancy in common, income from that property is generally taxed 50 percent to each joint owner. If joint ownership is other than equal (50/50), taxation follows the percentage of ownership.
Dividing deductions is also fairly simple. A spouse who pays an expense with separately owned funds is generally entitled to that deduction. Deductions paid out of a jointly owned account are presumed to be split 50/50 between each spouse. However, that presumption may be rebutted by one spouse establishing that he or she alone paid the expenses.
Community property states
There are 10 community property states: Alaska (if elected), Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin (and also Puerto Rico). In these states, what constitutes "community income" and what constitutes "separate property" are determined by state law. There can be some variation by state. Generally, each spouse is taxed on one-half of community income and on 100 percent of his or her income from separate property. When deductions are paid from community property, they are presumed to be split 50/50 between each spouse. When deductible expenses are paid from separate property, the property's owner is entitled to the deduction.
There is an exception to the general rule, however. Community income may be treated as separate income for federal tax purposes if all of the following conditions are met:
- The spouses live apart at all times during the year
- They do not file a joint return
- At least one spouse had earned income--such as wages, which is considered community income--during the year
- No portion of such earned income is transferred between the spouses during the year (except for mandated child support and de minimis amounts)
If all of the above conditions are met, the following rules apply:
- Earned income will be taxed only to the spouse who earned it by performing services (i.e., it won't be considered community income)
- Trade or business income is taxed to the spouse carrying on the business
- Partnership income is taxed to the spouse who is the partner
- Social Security benefits are taxed to the spouse receiving them
- Income from separate property is taxed to the owner of the property
- All other community income (e.g., interest, dividends, rents, royalties, gains) is taxed as provided by state community property law
For more information about community property, see Community Property and Property Settlement.
What about tax carryforwards?
The final joint return of a divorcing couple may contain various types of tax carryovers, which could be used to reduce tax liability in future years. Examples of these include capital loss carryovers, charitable contribution carryovers, and net operating loss carryovers. IRS regulations specify what happens to some of these carryovers in the event of a divorce. When the tax regulations don't specify how the carryforwards should be allocated between the divorcing spouses, the couple must allocate the carryforwards themselves. In many cases, the carryforwards may qualify as marital assets, the allocation of which should be subject to negotiation.
A more detailed explanation of tax carryforwards is beyond the scope of this discussion. For more information, consult additional sources.
What is a financial affidavit and how is it used in a divorce context?
When divorce proceedings are commenced, each spouse is required to fill out a financial affidavit. This form, which becomes part of the court record, shows income from all sources, including debt, living expenses, and assets. Each party declares (under the pains and penalties of perjury) that the information contained on his or her affidavit is true.
A judge will use the information contained in this affidavit when he or she issues temporary orders regarding separate maintenance (temporary alimony), child support, and other financial matters during the period of separation. The document is useful, moreover, to attorneys. The financial affidavit becomes the basis for seeking (or arguing against) temporary support and assists the attorney later during the discovery and property settlement phases of divorce.
For more information about these areas, see Property Settlement.
What can happen if you underreport your income or exaggerate your expenses?
Because you sign the financial affidavit under oath, deliberately falsifying your financial information can be considered perjury. Additionally, if your divorce ends up in trial, your credibility as a witness will be seriously undermined if your spouse's attorney can prove that you lied in your affidavit. This, of course, may sway the court's sympathy toward your spouse. And finally, even if your case never makes it to trial, your spouse may be able to force a property settlement in his or her favor if you are caught lying in a court document.
Example(s): John handled the finances in his family and secretly stashed away $50,000 in a bank account during the last years of his marriage. When divorce proceedings began, he wire-transferred the money to his mother, a resident of Colombia. John's wife, Mary, learned of the money when she found a receipt for the wire transfer in her husband's coat pocket. Since John had not disclosed the existence of this money at discovery or in his financial affidavit (submitted to the court), Mary was able to use this fraudulent transfer as an ace in the hole to force a favorable property settlement.
It's not uncommon for spouses to be less than truthful when completing their financial statements. If you suspect that some assets haven't been disclosed by your spouse, there are a number of places where you (or your attorney) can look for these hidden assets. The following documents should be scrutinized:
- Personal income tax returns
- Partnership and corporate tax returns
- Pay stubs
- Savings account passbooks
- Canceled checks and check registers
- Securities statements
- Children's bank accounts
However, it's often the case (with married couples) that one spouse handles the bills and other financial affairs for the sake of convenience. The other spouse may or may not be well informed. Therefore, it may be difficult for a spouse to determine if the other party is being truthful in the affidavit. Fortunately, you and your attorney will have many other opportunities to engage in fact-finding.
For more information about hidden assets, see Property Settlement.
What are some of the more common mistakes people make when completing financial affidavits?
Sometimes hidden assets aren't the problem; frequently, people unintentionally underestimate their expenses. For example, if you note your monthly grocery bill as under $150, you're spending less money than most people. For one person, approximately $200 is typical. And if you get a haircut every six weeks or so, be sure to include the cost under miscellaneous or personal care.
Under the heading "Health Insurance," many mistakes are also made. Often, one spouse will put nothing in this expense category because he or she is not currently making an insurance payment. If you're going to be taken off your spouse's plan shortly, you can call the benefits department of your spouse's employer to find out how much the COBRA payment will be. For more information about health insurance and COBRA, see Divorce and Risk Management.
Under the "Miscellaneous" section of the affidavit, don't forget to include gifts (e.g., Christmas, birthday, wedding), newspaper and magazine subscriptions, cable TV, pet food and pet care, lawn service, etc.
Note: Don't exaggerate your expenses. During a deposition or at trial, you'll be asked to defend your figures.
What information must you provide in your affidavit?
You'll probably be asked about the following:
- Name and address
- Occupation and job title
- Employer's name and address
- Frequency of your paychecks (e.g., weekly, biweekly, monthly, etc.)
- Monthly gross pay
- Type and amount of monthly payroll deductions
- Net monthly take-home pay
- Other sources (and amounts) of income
- Net monthly income from other sources
- Monthly housing expenses
- Monthly utility expenses (e.g., gas, electric, telephone, water and sewer, trash)
- Monthly grocery bill
- Monthly restaurant and entertaining expenses
- Monthly unreimbursed medical expenses (e.g., doctor, dentist, prescriptions)
- Monthly insurance expenses (e.g., life, health, disability, homeowners)
- Monthly transportation expenses (e.g., fuel, repair and maintenance, insurance, parking)
- Monthly clothing expenses
- Monthly child care (and child-related) expenses
- Monthly personal care and toiletries
- Educational expenses
- Miscellaneous expenses
- Debts of all kinds, including car loans, mortgages, 401(k) loans, student loans, etc. (monthly payment, unpaid balance)
Because divorce is based on state law rather than federal law, each state will have its own requirements regarding the financial statement. Nevertheless, the information listed is fairly typical.
What is debt and how is it classified for divorce purposes?
Debt is classified as marital or separate. In general, both spouses are responsible for any debts incurred during the marriage--it doesn't matter which party actually spent the money. When the property is divided up at the time of divorce, it's often the case that the person who gets the asset also gets the responsibility for paying any loans against that asset. And even if your spouse agrees to take over the debt, joint obligors on a loan will remain jointly responsible. That is, the creditors can seek payment from either one of you.
There are basically four types of debt to consider: secured debt, unsecured debt, tax debt, and divorce expense debt.
- Secured debt--Secured debtgives the lienholder or lender a right to repossess the property in the event of your default on the loan. Some examples of secured debt include mortgages on your real estate, car loans, and boat loans. If a loan stands in the joint names of you and your spouse, you'll need to make it very clear in your separation agreement who will pay which debt. If one spouse fails to make timely payments, the creditor can pursue the other spouse or, eventually, seek repossession.
- Unsecured debt--Unsecured debt involves no repossession, although there are other remedies. Typical examples of unsecured debt include credit cards, personal bank loans or lines of credit, and loans from family and friends.
- Tax debt--If you sign a joint return with your spouse, you're each liable for the tax debt. For three years after your divorce, the IRS can perform a random audit of your joint tax return. To avoid potential tax problems in the future, your divorce agreement should spell out what happens if any additional interest, penalties, or taxes are found.
- Divorce expense debt--Divorce can be expensive, and sometimes a spouse will seek a court order to make the other party subsidize attorney's fees for both sides. This might, for example, happen when only one spouse works. Since the homemaker-spouse may have no income to pay for a divorce attorney, a judge might order the working spouse to pay.
- Sometimes both parties work or have sufficient funds with which to retain attorneys. In these cases, you'll need to spell out who pays for what. For example, if both parties want the family business, the family home, or a pension to be appraised, you'll have to apportion the costs. The same holds true if you both decide to transfer title to an asset after a divorce.
- Debts can also be incurred during the separation period. If luxuries are purchased during this period, courts are likely to assign the debt solely to the party who ran up the debt. In general, debts incurred after the separation date and before the divorce is final are the responsibility of the spouse who incurred them. One exception would be for family necessities (e.g., food, clothing, shelter, and medical care). These necessities could be the responsibility of the other spouse if the incurring-spouse can't afford to pay.
What are the rules regarding credit card debt?
Either signer on a credit card can be held responsible for 100 percent of the debt, not just one-half of the debt.
Example(s): Assume John and Mary are seeking a divorce. During their marriage, John handled the finances and Mary stayed home with the children. During the discovery period of their divorce, Mary learned that John ran up over $30,000 on their joint credit cards to pay for his expensive suits, dinners for friends, recreational pursuits, etc. Since they live in a community property state, all assets and debts will be divided down the middle. Thus, Mary will be responsible for paying $15,000 of the debt (from a judge's perspective). However, if John fails to keep up with his monthly payments (or, if he decides not to pay any of his $15,000), the credit card companies can go after Mary for the full $30,000--the divorce settlement is not binding on creditors.
During divorce proceedings, several issues can arise regarding credit cards, such as removing a spouse as an authorized signer on a credit card and understanding the obligations of joint credit card owners versus single card owners with two authorized signers.
For information about these and other topics, see Credit Cards.
Will your former spouse's bankruptcy affect you?
Bankruptcy law allows debts between ex-spouses to be wiped out; therefore, the assets you were promised in your divorce settlement may never materialize. Be aware of this if you are considering the use of a property settlement note (a form of promissory note) to equalize a property division.
Example(s): Assume John and Mary wanted to divide their assets 50/50. After assigning the house to one and the pension to the other, John still owed Mary $40,000. John signed a property settlement note to Mary, promising to pay her the $40,000 over a five-year period at 7 percent interest. After the divorce, John filed for bankruptcy and listed the note as one of his debts. The debt was discharged, and Mary never got her money.
Tip: Note: Alimony and child support can't be discharged in bankruptcy. In the example, alimony should have been considered as an alternative to the property settlement note. For more information about property settlement notes, see Property Settlement.
If your ex-spouse files for bankruptcy, other problems may arise for you. While a bankruptcy might wipe out your spouse's obligation to pay marital debt, it doesn't wipe out your own. The creditors can contact collection agencies about you (damaging your credit) or sue you for the full amount of the debt. For more information about bankruptcy, see Bankruptcy.
How do you divide debt at divorce?
Basically, you have five options in allocating your marital debts:
- You and your spouse can sell joint property to raise the cash to pay off your marital debts
- You can agree to pay most of the debts; in return, you can request a greater share of the marital property or a corresponding increase in alimony
- Your spouse can agree to pay the bulk of the debts; in exchange, your spouse gets a greater share of the marital property or increase in alimony
- You and your spouse divide your property and debt equally; that is, each of you gets half of the property and each of you agrees to pay one-half of the debt
- If you're a homemaker with children, your spouse might be ordered to pay the bulk of the debt, pay alimony, and possibly allow you to keep the house and a portion of other significant assets, such as your spouse's pension
Because of the threat of bankruptcy and/or damage to your credit report, it might be wise to sell joint assets to pay off debt or to assume responsibility for debts yourself.
How can you repair your credit after a divorce?
Credit problems generally stay on your record for seven years, while bankruptcies can remain for up to 10. For more information, see Bankruptcy. There are some steps you can take to repair credit damaged during a divorce:
- Obtain a copy of your credit report and look for errors. Sometimes, your credit history may be confused with someone who has a similar name.
- Meet with a consumer credit counseling representative, who can provide you with tools to negotiate with your creditors. He or she can also give you some useful suggestions for paying your bills.
- Open a secured credit arrangement with your bank. If you deposit a specific sum of cash with a bank (such as $500), the bank will sometimes provide you with a secured credit card. Making timely payments will help to repair your credit over time.
For more information, see Repairing Poor Credit.
What questions (relative to debt) should you consider before entering into a divorce settlement agreement?
Before sitting down with an attorney, think about which debts were contracted prior to marriage (separate debt) and which debts were contracted during the marriage (marital debt). With respect to marital debt, consider the following questions:
If, pursuant to the divorce agreement, your ex-spouse assumed responsibility for all credit card debt, what are your legal remedies if he or she defaults? How can the divorce agreement be enforced?
- If you wish to keep a particular marital asset, will you have sufficient income to keep up with the loan payments?
- Should you liquidate other assets to retire the debt completely (or partially)?
- If your spouse proposes a property settlement agreement, is there a possibility that he or she would subsequently declare bankruptcy?