Contemplating Divorce: New Tax Law Has Significant Impact

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Nov 01, 2018

By Kim Vine, CPA Partner at Terry Lockridge & Dunn

The Tax Cuts and Jobs Act (TCJA) does a complete “180” to the tax treatment of alimony payments. Under this new law (divorces finalized after December 31, 2018) alimony payments will no longer be deductible by the payor, and they will become non-taxable to the recipient. Under the previous rules (i.e., divorces finalized by December 31, 2018), the alimony payments were tax deductible by the payor and were reportable as taxable income by the recipient.

Because the spouse paying the alimony is often in a higher tax bracket than the recipient spouse, the previous law resulted in net overall tax savings for the couple. For example, a spouse in the 45% bracket paying $100,000 in alimony saved $45,000 in taxes. If the spouse receiving the payment was only in the 30% bracket, he/she would only pay $30,000 in taxes on the receipt of that alimony. By reversing the law, the government, in a situation such as this, will obtain additional taxes of $15,000. However, once alimony becomes nondeductible, the payor spouse in this example, would clearly be inclined to demand a smaller alimony payment since he/she no longer has the $45K income tax deduction to cushion that $100K payment. To net out to the same cost, the payor would likely argue for a payment closer to $55,000. The recipient spouse receiving this $55,000 under the new tax law would not owe income tax on it, but he/she was better off under the old law taxation policy whereby she received the $100,000 and paid $30,000 on it, netting $70,000.

There are a couple of points to draw from this. First, for divorces finalizing after December 31, 2018, it becomes more important than ever to include tax planning in your divorce negotiations. There may be opportunities to use less alimony and more property settlement in your agreement. Property settlements (such as an investment, real estate, or a retirement account) may provide an overall more tax efficient way for the parties to reach an equitable agreement.

Also, if you have a divorce agreement very close to finalizing, it is likely to make sense for you to finalize it by December 31, 2018 (i.e., before the new law kicks in), especially if it involves alimony payments between ex-spouses who are in very different tax brackets.

Besides the alimony provisions of the TCJA, the Act also made other changes that will more indirectly affect the tax effects of divorce. For example, most closely held businesses will see some form of tax cut which can then affect the valuation of that asset in the marital estate. Also, in most cases, property taxes on personal use real estate will no longer result in an income tax savings (due to TCJA limits on the deduction for state and local taxes, as well as the new larger standard deduction), so a spouse who receives a home in a settlement may no longer have that tax deduction to cushion the cost of home ownership.

The accountants at Terry Lockridge & Dunn can guide you through the complexities of tax planning for divorce. They can be reached at 319-364-2945 in Cedar Rapids or 319-339-4884 in Iowa City.