Going through divorce is a difficult experience, even if both soon-to-be-ex-spouses agree it is for the best. When multiple factors are involved, such as splitting assets and child support, it can get emotional and even ugly.
The subject of alimony is often a hot button in divorce proceedings. When the couple decided to start a family, did one parent leave his or her career for child-rearing and homemaking? This narrative persuades many judges to award alimony, but it’s just one of many.
Regardless of the reason, the whole purpose of alimony is to audit the incomes of the former couple. The bigger the income inequity, the more likely alimony will be granted.
For years, having worked with clients in the middle of divorce proceedings and in need of a tax attorney, I knew the federal government offered some tax relief on alimony payments for both the payee and the payor.
In any case, unless the split with your spouse happened before the 2019 Tax Cuts and Jobs Act, alimony payments and taxes have gotten only more involved and expensive. This article should shed light on the new rules.
Get to Know the New Alimony Law
The Tax Cuts and Jobs Act eliminated the tax deduction for payers of alimony. This change applies to new divorce agreements settled after December 31, 2018. Along with eliminating the tax deduction for the payor, the change also eliminates the previous requirement on the receiving spouse to include the alimony payment in their taxable income. While this might seem like a score for those receiving alimony, it may not benefit everyone.
The old rule requiring the alimony money to be taxed on the side of the recipient was actually a pretty big benefit to both payers and receivers. This is usually the case when the paying spouse is a middle-class wage-earner in a higher tax bracket than the recipient. There are two specific benefits for parties to an alimony agreement in this financial situation under the old rule.
The first benefit was the payor’s ability to deduct the income being a significant tax break because the payor can exclude the income completely from his or her taxable income. In some instances, this prevents the amount of money that would have pushed the payor into a higher tax bracket from being taxed at the marginally higher rate.
The second tax-reducing measure was allowing the money to be taxed at the recipient’s end. In many cases, the recipient’s income was taxed at a lower rate which meant there are more post-tax dollars for both sides to share.
Tax Deductions for Divorce Agreements Prior to 2019
If you have an alimony agreement in place which was finalized before January 1, 2019, you are grandfathered into the old rules. This means you can continue enjoying the deductions taken in correspondence with alimony payments.
However, you should first be sure that your payments qualify as alimony, even if your alimony agreement was made in family court. As a reminder, family court judgements do not supersede the tax code. In order for spousal support payments to be considered alimony, and therefore tax deductible, your agreement should be consistent with the following requirements under the tax code:
- The payments must be required under a divorce or separate maintenance decree or written separation agreement;
- The payments must be paid in cash (debit is allowed, but no bartering for goods or services);
- There must be no liability for payment after the death of the recipient;
- The spouses may not live in same household; and
- The divorce or separate maintenance decree may not designate the payment as anything other than alimony—for example, child support.
It is necessary that payments deducted as alimony are consistent with these requirements, otherwise you could face the IRS making a claim that you mischaracterized what should actually be a taxable property distribution. There is also an additional concern worth mentioning to avoid tax liability that consists of two rules. These two rules may invalidate your deductions under what is known as “Recapture.”
What Is Recapture
Deductions for alimony can provide a significant opportunity for tax-payer savings depending on your tax bracket – you can have almost 50 percent of your tax liability reduced by the deduction. This means your federal tax liability could potentially double if it gets kicked out under IRS recapture rules. This makes it doubly important that you are familiar with recapture rules and the tax-deductibility requirements for alimony.
Here are the two rules you should be cautious of under recapture:
- The 3-year rule
- $15,000 limit on changes in payment
Spousal support is meant to be paid over an extended period of time. Property distributions can be paid out in any manner you prefer, but they do not get the tax deductibility benefit that alimony gets. This is the reasoning behind the 3-year rule. Under this rule, if the alimony payment is paid out in one-lump sum, you may lose the deductibility benefit by recapture. The payment term must be paid out over a minimum term of three years.
The second deduction recapture rule is that there is a cap on how much alimony payments can vary from one year to the next.
If your total settlement amount is split into co-equal payments, you do not have to worry about violating this rule. This rule is a concern for those who prefer a “step-up” or “step-down” payment plan. This is a payment plan where the payment amounts either start small and increase each payment until the balance is complete; or start with a large up-front payment and decrease with each payment, respectively.
If you chose this payment plan, just be sure that the amount paid in alimony does not vary more than $15,000 from one year to the next.
Example 1: 1st Payment $24,000; 2nd year Payment $12,000, 3rd year Payment of $0; there would be no violation of the $15,000 limit for changes in payments between calendar years
Example 2: 1st Payment $100,000; 2nd year Payment $50,000, 3rd year Payment of $0; there would be a violation of the $15,000 limit for changes in payments between calendar years.
Opting Out of the Previous Rules through Modification
While you do not have the option to opt-in to the old rules if you did not finalize your alimony settlement before December 31, 2018; if your settlement was finalized before the deadline, you have the option to modify your settlement and opt-out of the old rules.
As mentioned above, the elimination of the alimony deduction going forward will be a loss to many. However, some may benefit from the changes. This may apply to parties where the payor may now be in a lower tax-bracket and no longer need the deduction; or the recipient is currently in a higher tax-bracket, and it would no longer make sense to have the money taxed on the receiving end.
How Will Alimony Payments Affect Your Taxable Income?
For alimony payments that were executed prior to 2019, there’s no change in the federal income tax arrangement. For the support to continue to qualify as tax-deductible however, payers must still satisfy the established list of specific tax-law requirements or be subject to recapture.
Alimony payments do not have to be itemized on the payer’s federal income tax return but payment recipients must continue to include alimony payments in their taxable income. Business as usual, as the saying goes.
However, starting January 1, 2019, anyone in divorce proceedings and bargaining with their soon-to-be-ex-spouses should keep in mind that alimony payments are no longer tax deductible due to the recent Tax Cuts and Job Act.
If your proposed divorce agreement includes multiple assets, alimony and child support, it’s a good idea to consult with a tax law professional. Call Brotman Law at (619) 330-9579 or visit www.sambrotman.com to set up a free one-hour consultation. The new rules can get complicated and the IRS is paying attention.