If you are in the process of negotiating a divorce or legal separation, time is running out to preserve the tax-favorable treatment of deducting alimony payments from taxable income as the payor. The deduction of alimony will be eliminated if it is paid pursuant to a divorce decree or settlement agreement entered into after December 31, 2018. Recipients of alimony payments will no longer have to include these payments as taxable income
If you are the spouse receiving alimony payments, you might be inclined to take alimony payments on a tax-free basis under the post-2018 tax rules. However, the deductibility of alimony payments and shifting of income from a higher income tax bracket (the paying spouse) to a lower tax bracket (the receiving spouse) increases the amount of income that is retained by the divorcing parties and lowers the amount that is sent to taxing authorities. Therefore, it is in both spouses’ best interest to finalize their divorce or legal separation before the end of 2018, and with proper consideration of the new tax law, if the goal is to maximize the wealth of both divorcing spouses.
If you previously entered into a divorce or legal separation before the end of 2018, there will be no tax change to the deductibility of alimony payments, unless both parties agree to legally modify their pre-2018 divorce or separation agreements which is an option should they both desire to do so.
It is possible under some interpretations that prenuptial agreements could also be considered a written instrument incident to a divorce and therefore the language addressing future alimony in prenuptial agreements should be considered as well.
On December 20, 2017, the House and the Senate passed the tax reform bill commonly referred to as the Tax Cuts and Jobs Act of 2017 (the “TCJ Act”) and it was signed into law by the President on December 22, 2017. As part of the sweeping modifications to the Internal Revenue Code, Congress enacted several changes to personal income tax brackets and other individual tax provisions. Almost all the personal income tax changes are set to revert back to the pre-2018 tax laws by January 1, 2026. However, the changes to the tax treatment of alimony payments are permanent.
There is no change in the federal income tax treatment of divorce-related payments executed before 2019. Nevertheless, for these payments to qualify as deductible alimony, payers must satisfy the following requirements:
- The payment must be made pursuant to a written divorce or separation instrument.
- Payment must be to or on behalf of an ex-spouse.
- Payment must be stated in the written instrument as alimony or spousal support.
- Ex-spouses cannot live in the same household or file joint income tax return.
- The payment must be made in cash or cash equivalents.
- The payment cannot be designated as child support or property payment.
- The payer’s tax return must include the payee’s social security number.
- The requirement for payment ends upon the payee spouse’s death.
What Should I Do Now?
The best course of action is to seek legal counsel from an experienced family law attorney to ensure the language of divorce separation agreements and prenuptial agreements properly include language addressing the impact of the Tax Cuts & Jobs Act of 2017. This language should include the mutual intention of the parties that any future modifications of alimony, by agreement or court order, should either reflect or not reflect the tax treatment of alimony under the TCJ Act. Even if a divorce cannot be completed before the end of 2018, careful consideration of potential future changes in the tax treatment of alimony should be considered and reflected in the divorce settlement agreements.
One potential resource for completing divorces prior to the end of 2018 is the use of private judges who can work more client-focused timeframes than traditional court dockets will allow. A private judge is a retired judge who has registered with the Ohio Supreme Court and has the powers and authority of an active judge, including hearing testimony and issuing legal rulings. Private judges are also subject to the oversight of appellate courts. When a private judge is employed, the parties will enter into a contract with the judge and will be responsible for the fees and expenses for his or her services.
Other Factors to Consider
If you are considering modifying your separation agreement within three years of your divorce, then alimony recapture rules may recharacterize some of your prior alimony deductions as nondeductible. The alimony recapture rule provides that alimony deductions taken in the first or second year after divorce could be reclassified as taxable income if:
- Alimony paid in the third year after divorce decreases by more than $15,000 from the second year or;
- The alimony paid in the second and third years is meaningfully less than the first year.
For couples with children, it is important to note that beginning with the 2018 tax year, if you claim a child as a dependent for tax purposes, you are entitled to the Child Tax Credit, which was increased to $2,000 per qualifying child under the age of 17. Divorcing couples with multiple minor children may wish to alternate or assign the dependency exemption (using Form 8332) within the separation agreement. There are several requirements for a child to be considered a “qualifying child” for dependency purposes and professional tax advice should be sought.
Prior to 2018, divorcing spouses could deduct legal and accounting expenses related to determining alimony as a miscellaneous itemized deduction. Under the new tax act, legal and accounting expenses associated with this aspect of a divorce is no longer deductible for federal income tax purposes for the tax years 2018 through 2025 as miscellaneous itemized deductions were eliminated for this period.
The recent tax reform creates a closing window of opportunity to preserve the favorable tax treatment of alimony payments. All written divorce settlement agreements must be completed by December 31, 2018, to retain the right to deduct alimony payments for tax purposes. An experienced and knowledgeable family law attorney should be engaged to navigate these new waters and ensure that all divorce agreements properly reflect the impact of the TCJ Act. For individuals seeking to expedite the conclusion of their divorce to maximize the collective wealth of the marital estate, the use of a private judge should be considered. The TCJ Act also introduced several new changes to established tax laws which effect divorcing couples and should be considered during the divorce settlement discussions as well. Contact Apple Growth Partners today to ensure the wealth of both parties is reserved prior to the new year.