Paying alimony – or receiving alimony – can have an effect on your tax invoice. Read this earlier than you get divorced.
In a divorce, a spouse or ex-spouse may be required by law to make payments to the other party. Because these payments are often significant, being able to deduct them or not can be a significant tax issue. Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, payments that met the tax definition of alimony could always be deducted by the payer for federal income tax purposes. And recipients of alimony payments have always had to report the payments as taxable income.
This old-law treatment applies to alimony paid under pre-2019 divorce settlements. But for payments made under post-2018 agreements, the picture is very different. Here’s the shovel.
No deductions for alimony required by post-2018 divorce settlements
The TCJA eliminated the federal income tax deduction for alimony payments required under divorce settlements entered into after 12/31/18. On the other hand, recipients of such alimony are not required to include them in taxable income.
This change can be expensive for those paying alimony, as the tax savings from being able to deduct alimony under the old laws could be significant.
You can still deduct alimony payments required by divorce settlements prior to 2019
Alimony payments from divorce settlements entered into before 2019 can still be deducted if a list of tax requirements is met. In this case, the alimony payments can be written off on the payer’s federal income tax return. It does not matter whether the payer makes deductions or not.
Recipients of payments required as a result of divorce settlements entered into before 2019 must include the payments in their taxable income.
When payments do not meet the tax definition of alimony, they are typically treated as either child support or marital property payments. Such payments constitute non-deductible personal expenses for the payer and tax-free funds for the recipient.
Conditions for deductible maintenance payments
Whether or not payments required by a pre-2019 divorce settlement qualify as federal income tax deductible alimony is strictly determined by the use of applicable language in our beloved Internal Revenue Code and related regulations. In principle, it does not matter what is in the divorce contract and what the divorced couple may intend. In order for a particular payment required by a pre-2019 divorce settlement to qualify as deductible alimony, all of the following requirements must be met.
1. Written Form Requirement
Payment must be made pursuant to a written certificate of divorce or separation. This term includes divorce decrees, separate alimony deeds, and deeds of separation.
2. Payment must be made to or on behalf of spouse or ex-spouse
Payment must be made to or on behalf of a spouse or ex-spouse. Payments to third parties such as attorneys and mortgage lenders are acceptable if made on behalf of a spouse or ex-spouse and pursuant to a divorce or separation agreement or at the written request of the spouse or ex-spouse.
3. The payment cannot be referred to as NO alimony
The divorce or separation deed cannot determine that the payment in question is not alimony, or effectively establish that it is not alimony because it is not deductible by the payer or not included in the gross income of the payee.
4. Ex-spouses cannot live in the same household or archive together
After a divorce or legal separation, the ex-spouses cannot live in the same household or file a joint 1040 for payments to be considered deductible alimony.
5. Cash or Cash Equivalent Requirements
Payment must be made in cash or in cash.
6. Cannot be child support
The payment cannot be classified as alimony or child support under the tax rules. The regulations on non-deductible child support are complicated and represent a nasty trap for unwary taxpayers.
7. Payee Social Security Number Requirements
In order for the payer to claim a child support deduction for a payment, the payer’s statement must include the payee’s social security number.
8. No obligation to continue payment after death of recipient
The obligation to make payment (other than payment of amounts in arrears) must cease upon the death of the receiving party. If the divorce papers are unclear as to whether or not the payments must continue, then applicable state law applies. If state law requires the payer to continue to make payments (to the estate or beneficiaries of the recipient) after the death of the recipient, the payments are not deductible as alimony. In other words, the payment obligation must expire when the recipient dies in order for the payment to qualify as a deductible alimony. Failure to meet this condition for cessation of payments in the event of the death of the beneficiary is the most common reason for lost alimony.
What can be done to compensate for the lost maintenance deduction?
Remember, all of the above requirements for deductible alimony are only relevant to payments required by pre-2019 divorce settlements. Going forward, deductible alimony and the associated federal income tax savings for payers will be history. But payers may be able to do something to make up for lost tax savings. Such as:
Divide the marital wealth wisely for tax purposes
Consider transferring assets with built-in tax liabilities to your soon-to-be ex instead of paying some or all of the non-deductible alimony that might otherwise be required to close the deal. Examples are valued securities held in a taxable brokerage account, a valued vacation home, and so on. When you transfer valued assets, the built-in tax liabilities go with you and become the other party’s problem.
Employer Stock Options Transfer
You can also gain a tax benefit by transferring in-the-money, vested non-qualifying employer stock options (NQSOs) with their built-in tax liabilities to your future ex.
Carry over IRA and qualifying retirement plan balances
These assets can be transferred from one soon-to-ex to another in divorce situations. With proper planning, the ex using the account balance will bear the tax consequences if funds are withdrawn from the transferred balance. So this is another way of dividing the assets in such a way that the loss of maintenance deductions can be compensated in whole or in part.
Redemption of shares in closely held companies
Tax law allows your closely held company to buy back shares owned by your soon-to-be ex without any tax consequences for you — with proper planning.
The final result
When you’re considering a divorce, you need to address important tax issues, and there can potentially be a lot of money involved. I recommend consulting with a tax professional experienced in divorce tax matters sooner rather than later to get the best results for yourself. Waiting too long could prove to be a costly mistake from a tax point of view, and you may have to live with that costly mistake for years. Finally, be warned that many otherwise competent divorce attorneys are not up to date on tax matters and may be reluctant to admit it. So don’t assume that your divorce attorney is ready, willing, and able to get you the best tax outcomes. You know what happens if we accept.