In divorce, one spouse or ex-spouse may become legally obligated to make payments to the other party. Because these payments are often substantial, being able to deduct them, or not, can be a significant tax issue. Before the 2017 Tax Cuts and Jobs Act (TCJA), payments that met the tax-law definition of alimony could always be deducted by the payer for federal income tax purposes. And recipients of alimony payments always had to report the payments as taxable income.
This old-law treatment continues for alimony payments made under pre-2019 divorce agreements. But for payments made under post-2018 agreements, it’s a much different story. Here’s the scoop.
No deductions for alimony payments required by post-2018 divorce agreements
The TCJA eliminated the federal income tax deduction for alimony payments required under divorce agreements that are executed after 12/31/18. On the other side of the coin, recipients of such alimony payments don’t have to include them in taxable income.
For individuals who pay alimony, this change can be expensive — because the tax savings from being able to deduct alimony payments under the old-law rules could be substantial.
You can still deduct alimony payments required by pre-2019 divorce agreements
Alimony payments required by divorce agreements that were executed before 2019 can still be deducted if a list of tax-law requirements is satisfied. In that case, the alimony payments can be written off on the payer’s federal income tax return. It doesn’t matter if the payer itemizes deductions or not.
Recipients of payments required by divorce agreements executed before 2019 must include the payments in their taxable income.
When payments fail to meet the tax-law definition of alimony, they are generally treated as either child support payments or payments to divide marital property. Such payments represent nondeductible personal expenses for the payer and tax-free money for the recipient.
Requirements for deductible alimony
Whether payments required by a pre-2019 divorce agreement qualify as federal-income-tax-deductible alimony, or not, is determined strictly by applying the applicable language in our beloved Internal Revenue Code and related regulations. In general, what the divorce agreement says and what the divorcing couple might intend does not matter. For a particular payment required by a pre-2019 divorce agreement to qualify as deductible alimony, all the following requirements must be met.
1. Written instrument requirement
The payment must be made pursuant to a written divorce or separation instrument. This term includes divorce decrees, separate maintenance decrees, and separation instruments.
2. Payment must be to or on behalf of spouse or ex-spouse
The payment must be to or on behalf of a spouse or ex-spouse. Payments to third parties, such as attorneys and mortgage lenders, are permitted if they are 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. Payment cannot be stated to NOT be alimony
The divorce or separation instrument cannot state that the payment in question is not alimony or effectively stipulate that it is not alimony because it is not deductible by the payer or not includable in the payee’s gross income.
4. Ex-spouses cannot live in same household or file jointly
After divorce or legal separation has occurred, the ex-spouses cannot live in the same household or file a joint Form 1040 for payments to qualify as deductible alimony.
5. Cash or cash equivalent requirement
The payment must be made in cash or cash equivalent.
6. Cannot be child support
The payment cannot be classified as fixed or deemed child support under the tax rules. The rules regarding what constitutes nondeductible child support are complicated and represent a nasty trap for unwary taxpayers.
7. Payee’s Social Security number requirement
For the payer to claim an alimony deduction for a payment, the payer’s return must include the payee’s Social Security number.
8. No obligation for payments to continue after recipient’s death
The obligation to make payments (other than payments of delinquent amounts) must cease if the recipient party dies. If the divorce papers are unclear about whether or not payments must continue, applicable state law controls. If under state law, the payer must continue to make payments after the recipient’s death (to the recipient’s estate or beneficiaries), the payments cannot be deductible alimony. In other words, the payment obligation must cease if the recipient party dies in order for the payment to qualify as deductible alimony. Failing to meet this requirement for payments to cease if the recipient dies is the most common reason for lost alimony deductions.
What can be done to compensate for lost alimony deductions?
Remember: all the preceding requirements for deductible alimony are only relevant for payments required by pre-2019 divorce agreements. Going forward, deductible alimony, and the related federal income tax savings for payers, are history. But payers can potentially do some things to compensate for the lost tax savings. Such as:
Make tax-smart division of marital assets
Consider transferring assets with built-in tax liabilities to your-soon-to-be ex in lieu of making some or all of the nondeductible alimony payments that might otherwise be required to close the deal. Examples include appreciated securities held in a taxable brokerage firm account, an appreciated vacation home, and so on. If you transfer appreciated assets, the built-in tax liabilities go with them and becomes the other party’s problem.
Transfer employer stock options
You can also gain a tax advantage by transferring in-the-money vested non-qualified employer stock options (NQSOs), with their built-in tax liabilities, to your soon-to-be-ex.
Transfer IRA and qualified retirement plan balances
These balances can be transferred from one soon-to-be-ex to the other in divorce situations. With proper planning, the ex who winds up with the account balance bears the tax consequences when amounts are withdrawn from the transferred balance. So, this is another way to divide assets in a way that can wholly or partially offset the loss of alimony deductions.
Redemption of stock in closely held corporation
The tax law allows you to have your closely held corporation redeem stock owned by your soon-to-be-ex with no tax consequences for you — with proper planning.
The bottom line
If you are contemplating divorce, there are important tax issues to address, and big bucks can potentially be involved. I recommend contacting a tax pro with experience in divorce tax issues sooner rather than later to get the best results for yourself. Waiting too long could turn out to be an expensive mistake tax-wise, and you might have to live with that expensive mistake for years. Finally, be warned that many otherwise-competent divorce attorneys are not up to speed on the tax issues, and they 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 results. You know what happens when we assume.