How to Avoid Paying Taxes on a Divorce Settlement

Divorce settlements can have very different tax outcomes depending on how they divide and structure the assets involved. This leaves many people looking for ways to avoid unnecessary taxes on a divorce settlement. While you can’t avoid taxes entirely, IRS rules allow for certain tax-free property transfers. And the tax treatment of alimony, retirement accounts, and asset sales varies too. The IRS bases its tax decisions surrounding divorce on the timing, structure and types of agreements already in place.

A financial advisor can help you navigate the tax liability you’ll face after a divorce settlement.

Alimony and Taxes

Focusing on alimony and taxes in a divorce is one way to help safeguard your finances

It is not uncommon for the higher-earning spouse to agree to alimony payments as part of a divorce settlement. These structured payments make up for any income gap between the two now-former spouses.  Sometimes, alimony payments continue indefinitely or until the recipient remarries.

According to the IRS, payments count as alimony under specific conditions.

• The spouses don’t file a joint return.
• The payment is in cash, which includes checks and money orders.
• The payment is to or for a spouse or former spouse made under a divorce or separation instrument.
• The spouses aren’t members of the same household when they make or receive payment. Note that this requirement applies only to legally separated spouses under a decree of divorce or legal separation.
• There’s no liability to make the payment in cash or property after the death of the recipient’s spouse.
• The payment doesn’t count toward child support or a property settlement.

Under certain circumstances, cash payments can include payments to third parties. However, in these cases, the payor cannot benefit from the alimony payments. For example, a payor might make alimony payments by paying the mortgage on the former spouse’s house. It would not count as alimony if the payor also continued to live in this home.

The IRS outlines what alimony does not cover:

• Child support
• Noncash property settlements, whether in a lump sum or installments
• Payments that are your spouse’s part of community property income
• Payments to keep up the payer’s property
• Use of the payer’s property
• Voluntary payments

New TCJA Rules

According to the Tax Cuts and Jobs Act (TCJA), if your divorce or separation instrument occurred on or before December 31, 2018, alimony payments are generally deductible by the payer. The payments also become taxable to the recipient under the pre-2019 federal rules. An exception can apply if the instrument was modified after 2018. However, the modification must expressly state that the newer tax treatment applies. ¹

For a divorce or separation instrument executed after December 31, 2018, any person making alimony payments generally cannot deduct them. Conversely, any person receiving payments generally does not include them in federal taxable income.

State tax treatment can differ from federal rules. This means the federal treatment does not necessarily determine how different states tax alimony.

Marital Property Settlements and Taxes

In many cases, spouses do not recognize a gain or loss when property is transferred between them or between former spouses because of a divorce. This is controlled by two sections of the law: U.S. Code Section 1041(a) and U.S. Code Section 2516.

Under Section 1041(a), the IRS doesn’t require taxes for property transfers between former spouses if that transfer occurs “incident to the divorce.” A transfer is treated as incident to divorce if it occurs within one year after the marriage ends or is related to the end of the marriage.

This does not apply to alimony. A transfer occurring within one year after the marriage ends can qualify under Section 1041 even if the divorce instrument does not require it.

A transfer made more than one year after the divorce can still qualify if it is related to the end of the marriage. Under IRS regulations, a transfer made within six years after the marriage ends is generally presumed to be related to the divorce if it is made under the terms of a divorce or separation instrument. A later transfer may still qualify if the facts establish that it was delayed because of circumstances that prevented an earlier transfer.

Section 2516

Section 2516 applies to certain property transfers made under a written agreement between spouses who divorce within a three-year period beginning one year before the agreement is entered into and ending two years afterward. Qualifying transfers are treated as made for full and adequate consideration for federal gift tax purposes.

If this section does apply, the IRS will consider any transfer as made “for full and adequate consideration.” This means you gave something up and received, in exchange, something of equivalent value. 

As a result, your taxable wealth remains unchanged, and no party owes taxes on the property.

Tax Basis Transfers

Any property transferred as part of a divorce keeps its tax basis. There is no step-up basis loophole in divorce proceedings. 

For example, say that you bought a portfolio of stocks for $200,000 during your marriage. This is its tax basis. Over the years, it has appreciated, and today this portfolio is worth $500,000. During the divorce, you receive the full amount and you decide to liquidate the whole investment portfolio. The IRS will consider $300,000 of this as taxable capital gains, calculated as the $500,000 sale price minus the $200,000 original purchase price.

The tax basis of these assets will not have changed during the divorce. As a result, many parties consider the embedded tax liability when dividing property. More recently acquired assets may have a higher tax basis relative to their current value and therefore less unrealized gain than otherwise similar assets held for a long time.

For example, two investment accounts may each be worth $500,000 but have very different after-tax values:

Receiving either account would give a spouse $500,000 of property at the time of the divorce, but selling Portfolio A would generally create substantially more taxable gain.

Specific Tax Planning Steps to Consider During a Divorce

Your opportunities to avoid taxes in a divorce settlement will vary from those of others in similar, but still unique, circumstances. In general, though, it pays to consider critical factors that can potentially affect your tax liability, including alimony and IRAs, primary residence tax provisions and the possibility of a loss carry-forward.

1. Alimony and IRAs

Should you get taxable alimony, it will count as compensation if you deposit it into an individual retirement account (IRA). 

Under the federal rules, taxable alimony received under a qualifying pre-2019 divorce or separation instrument can count as compensation for IRA contribution purposes. Alimony that is not taxable under the post-2018 rules does not count as compensation for this purpose. Normal IRA contribution limits and eligibility requirements still apply.

To avoid taxes when splitting a retirement account it is usually necessary to have a qualified domestic relations order (QDRO). This establishes that one spouse has a claim to some of the other spouse’s retirement plan accounts. The QDRO will detail what belongs to the non-participant spouse and the number of payments or period to which the order applies.

One benefit of a QDRO is that it allows for early withdrawals from a 401(k) or other qualified retirement plans without incurring a penalty. A spouse or former spouse who receives a distribution from a qualified plan under a QDRO generally does not owe the 10% additional tax on that distribution. However, the distribution is generally taxable unless it is rolled over tax-free when eligible.

A QDRO can apply to any pension or retirement account covered by the Employee Retirement Income Security Act (ERISA). In other words, you don’t need a QDRO for individual retirement accounts (IRAs), which do not fall under ERISA.

IRAs work differently. A transfer of an interest in an IRA to a spouse or former spouse under a divorce or separate maintenance decree can be tax-free if it is completed under the applicable IRA transfer rules. Simply withdrawing money from an IRA and paying it to an ex-spouse can instead create taxable income and potentially an early-distribution penalty for the IRA owner.

2. Filing Status

If you’re still legally married at the end of the year, the IRS generally considers you married for the entire year. You may be able to file a joint return or use married-filing-separately status. A joint return can produce a lower tax bill in some circumstances, but both spouses generally become jointly responsible for the tax, interest and penalties associated with that return.

You can also file as head of household, but this only works if you meet certain conditions. A married taxpayer considered unmarried for head-of-household purposes generally must:

• File a separate return
• Pay more than half the cost of keeping up the home for the year
• Have a spouse who did not live in the home during the last six months of the year
• Have a qualifying child live in the home for more than half the year, subject to limited exceptions

If you meet these terms, you may benefit from a bigger standard deduction with more forgiving tax brackets.

For 2026, the standard deduction is $24,150 for head-of-household filers, compared with $16,100 for single filers and married taxpayers filing separately and $32,200 for married couples filing jointly.If you meet these terms, you may benefit from a bigger standard deduction with more forgiving tax brackets.

3. Child Care

Generally, the custodial parent is the parent with whom a child lives for the greater number of nights during the year. The custodial parent may sign Form 8332 to release the claim to the child for certain federal tax benefits so that the noncustodial parent can claim the child, assuming the other requirements are met. Parents can make the release for one year, multiple specified years or future years.

A Form 8332 release can allow noncustodial parents to claim the Child Tax Credit or other dependent credits when eligible. It does not transfer eligibility for head-of-household status, the Earned Income Tax Credit or the child and dependent care credit. Those benefits generally remain tied to the applicable residency and other requirements.

If you keep paying a child’s medical bills after the divorce, you can include those medical expense deductions. However, medical expenses must exceed 7.5% of adjusted gross income to qualify for deduction. Your child’s bills count toward this total alongside your own.

4. Primary Residence

If you sell your house during divorce, you may still be able to avoid taxes on the first $500,000 of gain, as long as you meet an ownership-and-use test for two of the last five years. The $500,000 exclusion generally requires a joint return and satisfaction of the applicable ownership and use requirements. Divorce does not by itself require selling the home before the divorce becomes final to preserve every available exclusion.

Special rules can help divorced or separated taxpayers satisfy the ownership or use tests in some situations. For example, a taxpayer may be able to count a former spouse’s period of ownership after receiving the home in a divorce-related transfer. A spouse who remains an owner may also be able to count time that a former spouse lives in the home under a divorce or separation instrument toward the use requirement.

Even if you don’t meet the full two-year residency test, a reduced exclusion may be available when the sale results from changes in employment, health or unforeseen circumstances. Merely owning or using the property for one year does not automatically create a $125,000 exclusion.

If you and your spouse still jointly own the home after your divorce, you can claim the tax exemption for its sale post-divorce. Each former spouse may potentially qualify for an exclusion of up to $250,000 on their share of the gain if they meet the applicable requirements.

Finally, your spouse can buy you out of the house without triggering any capital gains. A qualifying transfer of the home between spouses or former spouses incident to divorce generally does not cause the transferring spouse to recognize gain or loss. The receiving spouse generally takes the transferring spouse’s adjusted basis in the property rather than receiving a new basis equal to the buyout price.

Who Can Claim Tax Deductions During a Divorce?

The division of tax benefits becomes significant during divorce proceedings, as it can impact both parties’ financial situations. Generally, the IRS has specific rules that determine which spouse can claim certain deductions. The IRS bases these rules on factors like custody arrangements and income levels.

For child-related tax benefits, the custodial parent is generally the parent with whom the child lived for the greater number of nights during the year. Special rules can allow the noncustodial parent to claim the child as a dependent for certain purposes. For this to occur, the custodial parent must sign Form 8332.

Use our income tax calculator to explore how deductions and credits impact your final tax liability.

If the custodial parent signs Form 8332, the noncustodial parent may claim the Child Tax Credit or credit for other dependents if eligible. The custodial parent may still qualify to use the child for the Earned Income Credit, head-of-household status, and the child and dependent care credit if they meet the requirements for those benefits.

Divorced couples who owned a home together may also wonder about mortgage interest and property tax deductions. Who can claim those deductions depends on several factors. These include ownership, who actually paid the deductible expense, and whether the taxpayer itemizes deductions. A spouse does not automatically receive the full deduction merely because they retain the home after divorce.

If both former spouses remain liable on the mortgage or own the property and each pays part of a deductible expense, the deduction may need to be allocated based on the amounts each actually paid and the applicable tax rules. A divorce settlement can specify financial responsibilities, but it cannot override federal requirements for claiming a deduction.

Given the complexities of tax deductions after a divorce, consulting a financial advisor can be invaluable. A financial advisor can help compare the after-tax value of settlement options, while a tax professional or attorney can address tax-filing or legal questions.

Retirement Accounts and Divorce

Retirement accounts require special attention in a divorce because they are often among the largest assets a couple owns.

Accounts like 401(k)s and 403(b)s, as well as pensions and similar employer plans, cannot be divided informally. Instead, a legal document must establish each spouse’s share. This is important because retirement accounts have their own tax rules and early withdrawal penalties. These usually do not apply to ordinary property.

Employer plans subject to the QDRO rules generally require a qualified domestic relations order before the plan can pay benefits to a spouse or former spouse as an alternate payee. A QDRO distribution generally becomes taxable for its recipient unless rolled over when eligible. The 10% early-distribution tax generally does not apply to a distribution from a qualified plan under a QDRO.

IRAs are handled differently. They do not use QDROs and are divided under the property settlement terms in the divorce decree. A transfer of an interest in an IRA under a divorce or separate maintenance decree can be tax-free. However, it must follow the IRA transfer rules. Once the receiving spouse owns the transferred IRA assets, normal IRA rules based on age and account type apply.

Dividing retirement accounts can also affect future tax liability. Each spouse should consider the tax treatment of the assets they receive. Pretax accounts like traditional 401(k)s and IRAs will generate taxable income when withdrawn. Roth accounts do not create taxable income if rules are met, so the after-tax value of each asset may differ even if the nominal balances look equal.

Including these tax implications in negotiations can help both spouses understand what they are actually receiving.

Bottom Line

There are several steps you can take to make sure that a divorce doesn’t mean a divorce from your money. In most cases, the IRS does not tax property transfers between ex-spouses as part of the divorce process. For divorce or separation instruments executed after December 31, 2018, the person receiving qualifying alimony generally does not include the payments in federal taxable income, and the person making the payments generally cannot deduct them. Different federal rules can continue to apply to qualifying pre-2019 instruments. Given all the variables entailed in divorce and taxes, having a financial advisor to help you through the process can be just as important as having an attorney.

Tips on Divorce-Related Finances

• Divorce can be heartbreaking, infuriating, frustrating and confusing. Unfortunately, it’s also a very complex financial situation. That’s why working with a financial advisor can be so helpful during a time like that. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Now that you know how taxes after divorce work in theory, let’s look at the nuts and bolts in practice. It’s time, sadly, to talk about the practicalities of filing taxes after a divorce.

Photo credit: ©iStock.com/tommaso79, ©iStock.com/erdikocak, ©iStock.com/TolikoffPhotography