What are tax implications? According to the World Law Dictionary, tax implications are the “effect that an action or decision will have on the taxes that a person or entity must pay.” So, the question becomes: what effect does signing a prenup have on the taxes that you must pay? In this article, we will dive into the tax implications of signing a prenup–what happens to taxes on separate property, community/marital property, and income, how filing jointly or separately may affect you, and the tax implications on alimony.
Taxes on separate property vs. community/marital property
There are many different kinds of taxes, income tax, property tax, sin tax, sales tax, corporate tax, capital gains tax, and much more. This section talks about separate and community/marital property tax. Before we get into the really fun stuff (taxes, yipee!), let’s take a step back and get a quick refresher on separate vs. community/marital property.
Separate property is the property that you get to keep to yourself and is not subject to division in a divorce. Typically in a prenup, you will outline what property is separate property (or, in other words, what property you don’t want to share in a divorce). On the other hand, community property (or marital property, depending on what state you’re in) is the property that will be divided in a divorce. You will also outline what you and your partner deem community/marital property in your prenup.
Now, what does all of this have to do with taxes, you say? Good question. Your tax implications should line up with what you outlined in your prenup. We believe this is best demonstrated by example. Michael and Jessica live in California (a community property state) and have a prenup that says all property accumulated before the marriage shall remain separate property. For Jessica, this means her apartment should be considered separate property because it was acquired before she married Michael. The property tax on that apartment is also her separate property, meaning she is obligated to pay any tax on the apartment, not Michael. The prenup also says that community property is anything jointly purchased (among other things). During their marriage, they purchased a lake house together. Who is obligated to the lake house taxes? You guessed it–they should both be obligated to the lake house taxes since it is community property.
Background on income taxes
Income tax is the money you pay to the government from the income you make for the year. Taxable income usually comes from employee compensation but may also come from business, investments, digital currencies, royalties, and more. In other words, any income, whether it’s from employee compensation, businesses, investments, etc., may be taxed. We know, we know, exciting stuff!
We should remind you that income tax can be taxed federally and by state, depending on what state you live in. Some states do not have an income tax, such as Alaska, Florida, Nevada, Tennessee, Texas, Washington, and Wyoming. If you live in any of those states, you don’t have to worry about state income tax, just the federal income tax. If you live in an income-tax state, then it’s a different story.
Some married couples file their yearly taxes jointly, and some file them separately. Filing jointly may allow married couples to qualify for certain tax credits because jointly, they have a higher household income which may hit certain income thresholds easier than if they were to file separately. Filing separately may cause higher tax rates and ultimately result in more taxes paid overall than their jointly filed counterparts. Filing separately may come in handy in certain situations, such as having large amounts of out-of-pocket medical expenses.
So, what happens to income taxes when you sign a prenup? Well, again, it depends on what exactly your prenup says, but HelloPrenup agreements contain an income tax clause that explains, in short, “we might file our taxes jointly, but that doesn’t mean that our separate property is now joint.” Think about it: if you outline in your prenup that X, Y, Z is separate property, but then you go and file your taxes jointly as a married couple instead of filing separately, it may seem counterintuitive to the prenup. An income tax clause in your prenup can help make sure that it’s clear: just because we’re filing jointly to reap the benefits of tax savings doesn’t mean we want to throw out our prenup and share everything 50/50.
Alimony and taxes
Alimony and taxes–is there a more fun topic than this?!? We think not! (Just kidding). Alimony, sometimes known as spousal support or maintenance, is the financial support paid from one ex-spouse to the more disadvantaged spouse. Now, you won’t necessarily discuss taxes on alimony in your prenup, but you will likely discuss what to do about alimony overall. Generally, prenups will either state that you and your partner have waived alimony altogether (meaning it is not on the table at all if you get a divorce), or you will keep it and leave it up to the court to decide on alimony. If you are choosing to waive alimony in your prenup, you likely do not have to worry about this section, as it probably won’t apply to you. However, if you are leaving alimony on the table and leaving it up to the court to decide, then you may want to keep reading. Prenups generally do not discuss the tax implications of alimony, though, but it’s still important to understand them.
The tax implications of alimony are slightly complicated. Recent tax reform changed everything in 2019. For those couples that finalized their divorce after January 1, 2019, the IRS no longer treats alimony as income, and the paying spouse is not allowed to treat it as a tax deduction. This can be a big deal for the paying spouse because they can no longer deduct the alimony payment. Let’s say you’re paying $20,000 per year in alimony, this alimony tax deduction used to reduce your taxable income, but now that same $20,000 is not deductible to reduce your income. In plain English? Those spouses paying alimony could end up paying additional thousands in income taxes. Things aren’t so bad on the other side of the fence. The person receiving alimony basically gets their money tax-free because they no longer have to claim it as income after January 1, 2019! As you can see, depending on whether you are at the receiving or paying end of alimony, your tax implications will differ drastically.
The tax implications of signing a prenup will vary depending on what exactly your prenup says! For example, you might have a clause that dictates what your filing status is (let’s say it’s joint). In that case, you and your spouse are required to file each year jointly, as per your own prenup. Also, some may worry about what the implications of filing jointly might be on a prenup. Not to worry, there are clauses you can include to make sure that just because you file jointly doesn’t nullify the prenup and make you guys now share everything, in contrast to your prenup. What is considered community/marital property as per the prenup (i.e., subject to division in a divorce) should also mean that the tax obligations on such property are also shared. What is considered separate property as per the prenup (i.e., not subject to division in a divorce) should similarly mean that the tax obligations on such property are also separate. Don’t forget about alimony! There are tax implications if alimony is awarded in your divorce, but you can’t really talk about it in your prenup. We just wanted you to be aware of that while we’re talkin’ ‘bout taxes.
Catch our drift? We hope this article didn’t put you to sleep; we know taxes aren’t the most exciting topic ever!
HelloPrenup can assist you in creating a prenup that helps protect you against unwanted tax obligations. A prenup is not a tax haven or some crazy loophole by any means, but you can certainly try to protect yourself against your spouse’s separate property tax while still reaping the benefits of filing taxes jointly and potentially even dictating your desired filing status during the marriage.
Nicole Sheehey is the Head of Legal Content at HelloPrenup, and an Illinois licensed attorney. She has a wealth of knowledge and experience when it comes to prenuptial agreements. Nicole has Juris Doctor from John Marshall Law School. She has a deep understanding of the legal and financial implications of prenuptial agreements, and enjoys writing and collaborating with other attorneys on the nuances of the law. Nicole is passionate about helping couples locate the information they need when it comes to prenuptial agreements. You can reach Nicole here: [email protected]