The New Tax Law and Divorce
January 15, 1998
The Taxpayer Relief Act of 1997 (“1997 Act”), which was signed into law on August 5, 1997, contains several provisions which affect the practice of divorce law. This article will highlight some of the key provisions.
Home Sale Gains Exclusions
In 1985, Congress repealed the Davis rule, under which the transfer of property in divorce could be a taxable event. The 1997 Act goes one step further in removing one of the last major capital gains impediments incident to divorce negotiations and procedure: computing and apportioning the capital gains tax on the parties’ principal residence .
Under the 1997 Act, capital gains on the sale of principal residences after May 6, 1997, can be excluded up to $500,000 if a joint return is filed and $250,000 for those filing as single or married filing separately. Most significantly, this exclusion defines “principal residence” as a residence owned and used as the main residence during at least two of the five years preceding the date of the sale of the home.
Prior to the 1997 Act, significant concerns arose when a temporary separation appeared warranted at the commencement of a divorce action. When a party moved out of the home, even on a temporary basis, it may have resulted in the loss of principal residence status to that party, which in turn meant loss of roll-over ability for any capital gain. The new legislation allows one of the parties to move out of the residence, yet retain primary residence status under most circumstances.
Where there are minor children, the presence of both parties in the home during the pendency of the action has frequently been an inducement for strife and friction. In the worst cases, this could lead to abuse and even in the best cases, this friction was a negative for children. Where custody is an issue, these temporary arrangements may be unavoidable, but in those circumstances where one party felt it incumbent to remain in the home to avoid adverse tax implications, the new tax law provides a peace offering. This truly is an infrequent example (unique?) of a tax law change which benefits children.
The 1997 Act also eliminates the inequity that existed when the courts all too frequently disregarded the crediting of a homeowner with the contingent capital gains. Previously, because it was possible that the person awarded the home could remain there until age 55, or rollover the gain into another house until age 55, the courts usually did not factor the potential capital gains tax obligation into the property division. The result was the risk of an early sale, which would commonly be induced by financial hardship. Accordingly, the capital gains would act to increase the hardship by imposing a tax on the hardship! In football terminology, this is known as “piling on”. Thankfully, all of those worries have been eliminated.
Child Tax Credit
The new Child Tax Credit provides cash relief to most taxpayers with children under age 17. However, the stakes in the battle over the award of the dependency exemptions for the children is raised as it appears the tax credit follows the holder of the dependency exemption.
Previously, the dependency exemption was worth, at most, the value of the exemption multiplied by the payor’s marginal tax rate. For those with low income, the exemption was worth little or nothing at all. Thus, in most of those cases, negotiations were made easy, as a child support payor with a large income can get far more value for the exemption than a payee with little or no income.
The 1997 Act provides a tax credit of $400 per child in 1998 and $500 per child in 1999 and thereafter. This credit provides two benefits for purposes of valuation and settlement: First, no arithmetic is required as the amount is simply a credit against taxes or can be paid to the parent. Second, the value of the credit is the same to both parties, regardless of the amount of taxable income – $400 is $400.
To be eligible to claim the tax credit, I.R.C. § 24(c)(1)(A) defines a “qualifying child” as one for whom “the taxpayer is allowed a deduction.” Under this definition, it appears that the credit cannot be split or awarded to the parent without the dependency exemption. You get the dependency exemption, you get the credit.
Without question, some parents who surrendered the dependency exemption in previous settlement negotiations will be dissatisfied with this rule and the prospect of post-judgment activity looms. Will this new tax credit be considered a substantial change of circumstances to modify the award of the dependency exemption now that it is worth more money than originally bargained?
If past experience serves as a guide, the answer will be “no.” Generally courts do not find changes in law to be substantial changes of circumstances, in and of themselves. Some of this reluctance is due to courts’ concern with opening the floodgates to litigation. Therefore, although that the new law will in all likelihood not be held to be a basis to change current orders, it will certainly be a basis to negotiate harder for the dependency exemption for new cases.
More difficult, but certainly not impossible. For instance, there are limitations to the credit under the new law. The credit begins to phase-out for payors with adjusted gross income of over $110,000 on a joint return, $75,000 for a single return and $55,000 for married filing separately. It continues to makes no sense to give the exemption and accompanying credit to a taxpayer who cannot benefit from either.
Also, as the credit is essentially a cash payment worth the same to both parties, a simple resolution comes to mind. Divorce lawyers long ago learned to divide by two. So, while the credit itself cannot be divided, divorce decrees can either alternate dependency exemptions year by year or, simpler yet, provide that the party with the exemption simply pay the other party one-half of the value of the credit ($200 in 1998 and $250 thereafter) by a designated date, designed to coincide with the filing of tax returns or receipt of anticipated refunds.
The 1997 Act makes numerous changes in areas which will affect families, including IRA withdrawals for new homes, college tuition tax credits and much more. However, the practice of family law will be affected the greatest by the child tax credit and capital gains treatment of the family residence.
This article originally appeared in The Compleat Lawyer.