How Has Tax Reform Affected Alimony?
In 2018, some of the most sweeping federal tax reform in decades took effect. The changes that got the most press were the ones that affected the most people, like the change to tax brackets, limitations on itemized deductions, and the increase in the standard deduction. While the issue of alimony and taxes may not have been on most people’s radar screen, divorce attorneys—and payers and recipients of alimony—were watching closely. The Tax Cuts and Jobs Act (TCJA) made a major change to the tax treatment of alimony (also called spousal support) and separate maintenance payments.
The TCJA was enacted in December 2017, but its provisions affecting alimony and taxes applied to divorces that were finalized after December 31, 2018. Alimony awards that were modified after that date were subject to the new law as well unless the parties specifically opted out.
How the TCJA Changed Alimony and Taxes
Prior to the enactment of the TCJA, alimony payments were taxable as income to the person who received them, and deductible from income to the person who was paying. Let’s say that Chris was earning $40,000 per year and Lee was earning $120,000 per year at the time of their divorce. They agreed that Lee would pay Chris $20,000 per year in alimony.
Let’s leave aside the existence of other deductions and focus only on alimony and taxes. If their divorce had become final on December 30, 2018, The alimony payments would have been deductible to Lee (the payer). Lee’s taxable income would have been $100,000 ($120,000 minus $20,000) and Chris’s would have been $60,000 ($40,000 plus $20,000).
However, if their divorce was finalized a week later, in 2019, the tax picture would have been much different for both Chris and Lee. Because alimony is not deductible to the payer under the TCJA, Lee’s taxable income would remain $120,000, and Chris’s would be $40,000.
What Counts as Alimony?
If you’ve been divorced, you know that there are many opportunities for money or assets to be transferred between ex-spouses, or those who are soon to be divorced. When does a payment count as alimony?
If your divorce was final before the end of 2018, or if you modified your alimony order afterward but agreed to opt out of the new rules, you need to know exactly what counts as alimony in order for payments to be deducted from the payer’s income. To be tax deductible, alimony payments must:
- Be paid according to the terms of your divorce judgment or other court order;
- Be paid in cash or by check (not in goods, services, or other property);
- Not be combined with child support or property settlement payments;
- Not be made between people who share a residence. For instance, if your divorce is final but you and your ex-spouse are both still living in the marital home, alimony is non-deductible;
- Not be made between people who are filing a joint tax return;
- Not continue to be payable after the death of the recipient spouse.
Payments are most likely to be recognized as alimony by the IRS when they are the same amount and paid on a regular basis according to a court order. It may seem more convenient to pay a few months of alimony at a time when you get your annual bonus, or lump your monthly alimony payment together with your child support payment on the same check. But if you still have the benefit of being able to deduct alimony payments from your income, those practices could put your deduction at risk.
How New Rules About Alimony and Taxes Affect Divorce Planning
Prior to the TCJA, payers of alimony could deduct alimony from their income, meaning that it was generally more attractive to them to agree to pay it (or to agree to more generous terms). For divorces that have become final since the enactment of the TCJA, that incentive has disappeared. On the other hand, since alimony payments are no longer taxable as income to the recipient, a lower-earning spouse would have a greater incentive to ask for spousal support than before.
As a result, the new law regarding alimony and taxes may have made it more difficult for divorcing spouses to reach agreement on this issue. The big winner of the TCJA’s rules about alimony is the federal government. Because taxes on alimony payments are now paid by the higher earner, who is likely in a higher tax bracket, the government gets a larger percentage.
Unlike many provisions of the TCJA, the rule about the deductibility of alimony does not “sunset;” it is permanent. That means payers and recipients of alimony, as well as family law attorneys, are going to need to learn to live with it.
If you are planning to divorce and believe alimony could be an issue in your case, be sure to consult with an experienced family law attorney who can help you understand the tax implications of any potential agreement. If you are already divorced, and your order for alimony is pre-2019, you should also consult an attorney before agreeing to a modification. Without including certain language in your new order, agreeing to modify the order could have major tax consequences.
To learn more about how alimony and taxes intersect, please contact Barton Wood to schedule a consultation to discuss your unique circumstances.