Divorce & Taxes: The Lesser Known Sibling To Death & Taxes
By: Jonathan Peyton
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For as long as I can remember financial professionals have joked that there are only two guarantees in this world; death and taxes. At first, I didn’t quite understand the joke but as my professional career seasoned I came to realize there was no escaping the IRS or father time.
Years later I came to find there is another unfortunate area where taxes seem to rear their ugly head: divorce.
In a previous article I wrote about how divorcees could expect to get screwed in many ways like how alimony was no longer deductible or how a divorcee’s tax bracket increases when they elect to claim Married Filing Separately (MFS) and then ultimately when they claim a Single filing status.
In this article I thought it was only appropriate to expand on those concepts for those considering divorce, or those about to be divorced.
I need you to understand how the IRS boogeyman intends to hit you up for more money.
It is important to note that I am not a tax advisor. Much of what I am about to cover comes from reading text, observing professionals, and helping clients. The content I will be referencing sources directly from my studies as a Certified Divorce Financial Analyst and through my studies to become an Enrolled Agent. Before taking any action related to your situation I encourage you to see tax advice from a tax advisor who understands your situation.
The New Tax Law Slap
During my studies to become an Enrolled Agent I found much of the tax law to be quite confusing, but not because the intricacies of the tax code were hard to understand. Rather, much of the code seems to be a game of where to put what in order to drive your adjusted gross income (line 37) down as far as possible.
Why does driving the Adjusted Gross Income (AGI) down matter for divorcees?
Well, the lower someone can get their AGI the higher their chance of not being subject to certain itemized deduction phaseouts. Never was this more evident than when we compare some of the “below the line” deduction phaseouts. For example:
In 2017 the Pease phaseout for itemized deductions was $261,500 for individuals and $313,800 for married couples. This meant that two separate individuals with incomes below $261,500 would be able to utilize more of their itemized deductions than if those same two people were married.
Another example of the marriage penalty was seen in the actual income tax brackets.
In 2017 the 28% marginal bracket for a married couple filing jointly ranged between $153,100 and $233,350 whereas a single individual ranged between $91,900 and $191,650. This meant that two unmarried individuals each making $190,000 would file individual tax returns and yet still remain in the 28% marginal bracket.
Whereas, in the same tax year, a married couple’s income above $233,350, up to $416,700, would be subject to an additional 5% (33%-28%) additional marginal tax rate.
So what does all of this tax jargon mean?
Fundamentally, from a tax perspective, prior to 2018 you were penalized for being married. Now in 2018 the marriage penalty is all but gone.
How you ask?
According to the recent Tax Cuts & Job Act, passed by Congress in December of 2017, the income brackets for married couples significantly expanded. For example, two individuals with the exact same income fall into the same tax bracket, up to 35%, regardless if they were married or unmarried.
What gets crazy though is the 2018 income bands on each tax bracket!
Remember those two people who were unmarried and each making $190,000 were subject to a 28% marginal tax bracket in 2017. Then they decided to get married and begrudgingly accepted part of their income subject to the 33% marginal bracket.
Well, the following year that same couple unfortunately found themselves divorcing. Thinking they would at least lower their tax liability back down to the 28% marginal bracket they received upsetting news from the accountant.
See in 2018, thanks to our benevolent Congress, had this couple remained married their marginal bracket would have increased to $35%, from 33%, based on the $380,000 income. However since they are not remaining married they will each be subject to a 32% marginal bracket, instead of what was a 28% marginal bracket.
Essentially this means there is a penalty for getting divorced. Talk about throwing salt in an already sore wound.
There is a pretty big ray of sunshine though… the Pease limit.
Where there once was a phaseout limit for high income individuals on itemized deductions prior to 2018, that limit has been suspended until December 31, 2025. This means high income earners will not be required to reduce their itemized deductions by 3% of any amount over the previously set $261,500 phase out limit.
So Long Alimony Recapture
I noted in my previous article that alimony was no longer going to be tax deductible for couples filing for divorce AFTER December 31, 2018. While sad for the payer, there are some important points to remember for those grandfathered under the “old” system.
It should be noted that over the years many states and jurisdictions have begun treating alimony as transitional support (for a period of time) rather than a permanent obligation. The laws of the state you file in will guide the conversation on how alimony will be treated.
For those individuals currently divorced and paying, or receiving, alimony you need to listen up. When one spouse pays alimony, the first three years of payments are CRUCIAL!
The first three years of alimony are subject to an alimony recapture rule test. What does this mean? Fundamentally this means that if the alimony payments drop by more than $15,000 between year two and year three then the payments could be deemed by the IRS as child support instead of alimony. If such payments are considered to be support payments other than alimony and payment drops more than $15,000 in the last two years then the payer would have to amend their prior year returns and claim those payments as income. The payee, on the other hand, would file amended returns and be able to remove that income from their taxes which means they would receive a refund for taxes paid.
Let that sink in… let me give you an alimony recapture example…
Let’s say spouse ‘A’ is set to pay spouse ‘B’ thirty thousand dollars for the first year and for the second year. The goal is to help spouse ‘A’ get back on their feet while they transition back into the workforce. Then in the third through tenth year the payments drop to ten thousand dollars annually. As wonderful as this plan might seem there is a problem.
See, in the third year spouse ‘A’ paid spouse ‘B’ ten thousand dollars. Since the payment dropped between years two and three by greater than fifteen thousand dollars the payer is now potentially subject to alimony recapture (the requirement to claim part of the payment on a prior year’s tax return).
In the aforementioned example either the payer or payee would subtract fifteen thousand dollars from the amount paid in year two and then subtract the alimony payment paid in year three. This tells you if any alimony is subject to recapture in year two.
If the alimony recapture in year two is positive then the individual will subtract the second year’s alimony recapture from the first year’s alimony payment. Take the byproduct and add it to the third year’s alimony payment.
Finally take the result of the previous calculation and divide it by two. Then add fifteen thousand. The result then needs to be subtracted from the first year’s payment. If the amount is positive then add the recapture for the first year and the second year together. This total amount will be what is claimed as income in year three by the payer. If the first year’s recapture was negative then subtract the alimony recapture for year one from year two to arrive at the amount that needs to be claimed in year three.
Wow… that was a mouthful. If your eyes and head aren’t spinning then you catch on quickly! For those that need a visual aid I am including an image for reference:
Regardless of when you started alimony, or will start alimony (up until 12/31/2018), both parties should be aware of how alimony recapture can affect both people in the first three years of payments. As a side note, if the payer fails to make a payment due to loss of job or other reason then the payer could be subject to alimony recapture rules.
When Alimony Is Not Alimony
Have you ever thought to yourself “I would love to just be done with my soon-to-be ex-spouse”. In situations like this one person might turn to the other person and say “I will just give you X% more of the martial assets instead of paying you alimony”. Sounds pretty reasonable and fairly straightforward but this is not a good idea for tax reasons.
See, in order to be treated as alimony payments the payments need to source from income, not from marital assets. If a lump sum payment sources from marital assets then that payment is not considered alimony and is not deductible by the payer.
Additionally, remember, for payments required under divorce or separation instruments that are executed after Dec. 31, 2018, the new law eliminates the deduction for alimony payments. Recipients of affected alimony payments will no longer have to include them in taxable income.
It should also be noted that if support payments are outlined in the divorce decree but are not explicitly stated to be “alimony” then in an IRS audit those payments can be disallowed as alimony. If this happens then both parties would need to amend prior year returns. The IRS can require the payer to amend all previous returns, even if those returns go further back than three years. On the other hand the payee can only go back three years which means they will not be able to collect any taxes paid beyond the last three years.
IRS Divorce Resource
For those going through divorce and wonder where to turn I always suggest enlisting the help of your divorce attorney, of a Certified Divorce Financial Analyst, and of your accountant. For questions that are more tax specific the IRS provides an entire publication (Pub 504) to help you understand the laws affecting separated and divorced individuals.
The last topic most individuals think about when dividing up what took them years to build are how taxes are going to impact their future. For those expected to pay alimony the reduction of cash flow will be felt in what is paid to the ex-spouse and potentially in what the IRS reaches in and pulls out every year.
I would love to say the tax talk ends there. However for spouses who fall on hard times and cannot pay their alimony they can be at risk of being affected by alimony recapture rules. This is why an attorney and their client should consider the ability to meet the alimony obligations over the following three years before committing to a payment stream. While no one can predict the future, it is always best to understand as many scenarios as possible.
Finally, according to the IRS, to be deemed as alimony the payments have to meet specific criteria. While providing a lump sum upfront to an ex-spouse may offer some finality to the divorce process, the IRS may consider the lump sum to originate from marital assets and not from income. This can mean the payer would not be afforded the opportunity to deduct the alimony allotment (for divorce and settlement agreements executed before 12/31/2018).
While the entire divorce process may feel like death to some couples, taxes can feel like an icy cold hand of IRS reaching into your pocket monthly.
The opinions voiced in this material are for general information only and are not intended to provide specific individualized tax or legal advice or recommendations for any individual. We suggest that you discuss your specific situation with a qualified tax or legal advisor.