Divorces cause tax issues, including which parent is allowed to claim valuable child-related tax breaks. Sometimes, but not always, it depends on which parent is allowed to claim the child as a dependent. Here's what you need to know.
Are You the Custodial Parent or the Noncustodial Parent?
For tax purposes, a child is usually treated as "belonging" to the parent who has custody for the greater part of the year. That parent is called the custodial parent. The other parent is called the noncustodial parent.
The general rule says that only the custodial parent can claim the dependent exemption deduction for the child. However an exception allows the custodial parent to give the noncustodial parent the right to claim the designated child as a dependent. Making this concession doesn't help the custodial parent's tax situation, but it's often a necessary part of settling the divorce. We will call this exception to the general rule the noncustodial parent rule. As you will see, it is an important tax-saving provision for all you noncustodial parents out there.
Noncustodial Parent Rule Can Translate into Major Tax Savings
Under the noncustodial parent rule, the designated child is treated as a qualifying child of the noncustodial parent if all the following requirements are met.
Support Requirement: Over half the child's support for the year must be provided by one or both parents.
Divorced or Separated Requirement: The parents must be divorced or separated under a written agreement at the end of the year or have lived apart during the last six months of the year.
Custody Requirement: The child must be in the custody of one or both parents for over half the year.
Written Declaration Requirement: The custodial parent must sign a written declaration releasing to the noncustodial parent the right to claim the designated child as a dependent for the year. To meet this requirement, have the custodial parent sign IRS Form 8332 (Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent). The noncustodial parent must attach a copy of Form 8332 to his or her Form 1040.
When all these requirements are met, the noncustodial parent is eligible for the tax breaks listed below with respect to the designated child. (Correspondingly, the custodial parent is ineligible.)
Dependency Exemption Deduction: This deduction is $3,800 for 2012; $3,700 for 2011.
Child Tax Credit: This credit is worth up to $1,000 for each eligible child (subject to phase-out for higher-income parents).
Higher Education Tax Credits: The American Opportunity credit can be worth up to $2,500 during the first four years of a child's college education. The Lifetime Learning credit can be worth up to $2,000, and it covers just about any higher education tuition costs. (Both credits are phased out as the parent's income goes up, but the Lifetime credit is phased out earlier.)
Student Loan Interest Deduction: This deduction can be for up to $2,500 of qualified student loan interest expense paid by the parent (subject to phase-out for higher-income parents).
Tuition Deduction: This deduction can be as much as $4,000 for higher education tuition and mandatory enrollment fees. (At higher income levels, the maximum deduction drops to $2,000 before being completely disallowed at still-higher levels.)
Important Point: When the noncustodial parent rule isn't in effect for a child, the breaks listed above are completely off limits for the noncustodial parent, but they can usually be claimed by the custodial parent.
Some Breaks Are Available to Both Parents
Whether the noncustodial parent rule applies or not, the noncustodial parent can usually claim the tax breaks listed below as long as the first three noncustodial parent rule requirements are met (the support requirement, the divorced or separated requirement, and the custody requirement). The custodial parent can also usually claim these breaks.
* Itemized deductions for the child's medical expenses paid by the parent.
* Tax-free employer-provided healthcare benefits for the child.
* Tax-free health savings account (HSA) distributions to cover the child's medical expenses.
Some Breaks Are Only Allowed to the Custodial Parent
The noncustodial parent cannot claim the following breaks based on a child to whom the noncustodial parent rule applies. The custodial parent can if he or she meets the applicable tax-law requirements.
Head of Household (HOH) Filing Status: Filing as an HOH is better than filing as a single taxpayer, because the standard deduction is bigger and the tax brackets are looser. A noncustodial parent cannot claim HOH filing status based on a child who falls under the noncustodial parent rule.
Earned Income Tax Credit: For 2012, this credit can be worth up to $3,169 for one qualifying child and up to $5,891 for three or more qualifying children. The credit is phased out as the parent's income goes up. A noncustodial parent cannot claim the credit for a child who falls under the noncustodial parent rule.
Child Care Tax Credit: This credit can range from $600 to $1,050 for one qualifying child; $1,200 to $2,100 for two or more--based on the parent's income. A noncustodial parent cannot claim the credit for a child who falls under the noncustodial parent rule.
Tax-Free Childcare Assistance: This break allows up to $5,000 in federal-income-tax-free reimbursements for childcare expenses under an employer plan. A noncustodial parent cannot receive tax-free reimbursements for a child who falls under the noncustodial parent rule.
For More Information
The rules I've explained here are not so easy to understand, even for tax pros. For more information, check out IRS Publication 504 (Divorced or Separated Individuals) at www.irs.gov.