By Diana Shepherd
Here are two topics you’d probably rather not think about: divorce and taxes. If you’re separated or newly divorced, however, it could be worth your while to get some good financial advice about both.
Also known as “maintenance”, spousal support is typically treated as taxable income to the person receiving it and tax-deductible for the person paying it. Before deciding whether a specific amount is going to work, you need to know what the actual out-of-pocket cost is if you’re the payor or the net amount that you’ll receive if you’re the payee. For example, if paying $30,000 in spousal support annually, how much is that $30,000 going to cost you after factoring in the tax deduction? And, if you’re receiving the $30,000, how much of that will you have to pay in taxes? For payments to qualify as spousal support with Canada Revenue Agency (CRA), they must meet a number of requirements; talk to your lawyer or Certified Divorce Financial Analyst® (CDFA®) professional to make sure you’ve met them all.
Generally speaking, child support is non-taxable income to the person receiving it and it is not tax-deductible by the person paying it. If you’re going to be paying both spousal and child support, you may be tempted to lump both payments together and call them “spousal support” so you can claim a bigger tax deduction. Sorry to burst your bubble, but CRA is wise to this “strategy”, which could land you in serious hot water! You can also end up owing back taxes, penalties, and interest if your support payments are not structured correctly in your agreement.
Usually, payments must be made directly to the recipient to be classified as support. But what if you’re going to be paying child or spousal support to an ex-spouse who has a genuine problem with money—a gambling addiction, for instance? “Third-party or specific-purpose payments can be considered support payments [under certain circumstances],” says Mary Krauel, CPA, CA, MBA, CDFA®, who practices in Mississauga and London, Ontario. “Specific-purpose payments may include rent, property taxes, insurance premiums, and educational or medical expenses for the benefit of the recipient.” This is helpful in settlements where there is a need to ensure that the support payments will be used by the recipient for necessary expenses while at the same time preserving the deductibility for the payor, she adds. “To guarantee deductibility--clearly state it in the agreement.”
You can deduct legal fees paid to establish, increase, or collect support payments; however, only the recipient of support may claim these deductions—not the payor. Ask your CDFA professional or accountant whether you can deduct any of the divorce-related professional fees before you file your taxes.
Make sure you’re taking advantage of all possible tax credits and benefits during and after divorce; if your agreement isn’t structured correctly, you may be unable to claim tax relief. Karen Hallson-Kundel, CGA, CBV, CDFA®, who practices in Winnipeg, Manitoba, points out that the separation agreement must specifically identify the parent who will claim the child in order to preserve the Eligible Dependant tax credit, for instance. “Families with two children can structure the separation agreement to indicate that each parent claims one child, effectively doubling the tax benefit,” she says. “Carefully planning this aspect of a separation agreement can save your family between $4,052 and $6,702 (depending on your province) for the 2012 tax year.” In the year of separation, have your CDFA professional or accountant crunch the numbers to see whether you should be claiming the spousal support or any allowable tax credits. “If you pay support and you are were separated for only part of the year, you may claim either the deductible support paid that year or allowable refundable tax credits—whichever yields the larger benefit,” says Karen Archibald. “For example, Sally and Joe separated on September 1, and Joe pays Sally $300 each month in deductible support. Joe would be far better off claiming the spousal credit of $10,527 versus the support of $1,200.” Of course, there are different tax credits and benefits available in each province or territory, so ask your CDFA professional about what is available in your area and for your situation.