Divorce, Alimony, & Taxes: The Details
There are important tax implications to consider regarding those paying or receiving alimony. If alimony is going to be at issue in your divorce, you certainly want to be aware of these implications as they can have a serious impact on your negotiations.
As an initial matter, “alimony”, simply refers to money that one spouse furnishes to the other spouse after separation for support. In North Carolina, there are no guidelines to determine how long or how much alimony a spouse should receive, so alimony can differ greatly from one case to the next.
Alimony is referred to by several different names; it may be called spousal support, financial support, subsistence, upkeep or maintenance just to name a few. It is important to note that any stream of support payments invokes alimony tax implications regardless of what it is called. That is to say, that calling the payments “maintenance” or referring to the payments as “property division” in your separation agreement does not circumvent Federal tax law.
The spouse receiving the alimony payments is not required to pay taxes on those payments like other earned income, as it is already being paid by the supporting spouse. Prior to 2018, alimony was treated as income, just as wages and salaries are treated, and generally taxed somewhere between ten and thirty percent. This is no longer the case.
For a receiving spouse, the notion that alimony cannot be deducted for the paying spouse should factor into how much alimony is sought. If a receiving spouse hopes to collect $1,000 in alimony per month, he or she needs to consider if the payer can afford these payments while footing the whole tax bill for themselves. In this example, if the tax rate for the supporting spouse is 25%, they need to make sure they have at least an excess of $1,250 per month to make up for the amount lost in taxes – $1,000 paid in alimony and $250 set aside for the IRS.
The spouse paying the alimony cannot deduct the payment on their taxes, despite being able to do so prior to 2019. If your divorce and alimony agreement was executed before the change, you can still deduct the payments as you have been. If your divorce takes place after January 1, 2019, you will not be able to claim a deduction and must pay taxes on all of your income.
Bear in mind that there is no withholding with alimony payments. For a working spouse paying alimony, it may be a good idea to have your employer withhold more to account for the fact that you will owe taxes on the income that you pay in alimony. It might even be helpful to pay quarterly taxes to make sure you aren’t stuck with a larger than expected bill at the end of the year. You certainly do not have to increase withholding or pay quarterly estimated taxes, these tips are merely suggestions on how to prepare so that you avoid a large tax bill when you it is time to file.
Additionally, if the paying spouse has failed to make payments, and there is a resulting arrearage, the court may order that interest on the arrearage be paid to the receiving spouse. The paying spouse may not deduct the interest on the arrearage either.
Special Consideration for Mortgage Payments
There are certain tax implications with regard to deductions when one spouse is paying the mortgage on the marital residence. For instance, if one spouse is paying the mortgage for the benefit of the other spouse who is still living in the residence, it can be treated as alimony.
This can be done regardless of whose name is listed on the house. For example, regardless of whether the house is only in the name of the payer or the recipient, if the receiving spouse is living in the home and the supporting spouse is paying the mortgage on that house, it can still be considered as alimony.
Another important tax implication that can arise in alimony cases is the alimony recapture rule. This rule applies when the alimony payments decrease substantially or end during the first three calendar years.
A substantial decrease is defined in the rule as one of two situations: when the amount paid in the third year plus $15,000 is less than the amount paid in the second year, or when the payments in the second and third years are averaged and this average plus $15,000 is less than the payments in the first year.
If the above defined substantial decrease occurs, the paying spouse must “recapture” any excess alimony over the first and second years. Those payments that were previously deducted will have to be reported and recaptured in the third year post-separation.
Recapture can be tricky, but if you think it is an issue in your case, feel free to use our recapture calculator.
Alimony and Maintenance Trust
An alimony trust is a vehicle that allows a receiving spouse to protect her ability to collect alimony when the paying spouse loses the ability to make alimony payments. The paying spouse would place a significant income-producing asset or piece of property into the trust, and the alimony payments would come from said trust. Not only will this protect the payments despite the paying spouse’s bankruptcy or insolvency, but it also allows alimony to be paid from the trust after the death of the paying spouse.
This arrangement could be beneficial for a spouse who fears her ex may lose his or her job and thus be unable to make the alimony payments. Say, for instance, the paying spouse is a professional football player – if the players and owners come to an impasse over a salary dispute and the result is a lockout, the player-spouse would cease earning income until the dispute were resolved. In such a situation it would be beneficial to the receiving spouse to have an alimony trust established in her favor, as it would protect her ability to continue to collect alimony payments. Same goes for someone who fears her spouse may be considering a risky business venture, or a spouse who fears her spouse will intentionally quit working to avoid paying alimony. There are many scenarios where the alimony trust could be beneficial.
The transfer of any piece of property into an alimony and maintenance trust avoids the otherwise applicable gift tax. The IRS has specifically carved out an exception for those transferring property to an alimony trust so long as the trust is created as part of the divorce settlement.