Life is full of milestones. It’s those significant events that we all go through at some point in our lives, like getting married, having a child, buying a home, a divorce, the death of a loved one, etc. Most of these events will affect not only our emotions and finances, but will also have significant tax implications that are often overlooked at the time of the event.
This section is devoted to providing tax information related to a variety of life events. It will be a useful guide that covers everything you need to know about the specific event that you are experiencing. It tells you what to expect, things to avoid, the possible consequences of making such a move, and different scenarios that may apply to the situation.
We hope that the information provided in this section will help you cope with any life event that comes your way and encourages you to seek professional assistance when necessary.
Divorce can be one of life’s most traumatic events and is seldom amicable. A couple must divide up their assets and establish separate households which, except for the wealthy, will bring about financial hardship and stress. Added to this financial burden are the legal costs and, where children are involved, custody and visitation issues. Not to be overlooked are the long-term financial issues of alimony and child support. Substantial tax laws have evolved to deal with these issues and are detailed below.
• Attorney Fees & Court Costs
• Property Settlements
• Primary Residence
• Filing Status
Attorney Fees & Court Costs – The general rule for legal expenses (including attorney fees, court costs, etc.) is that they are tax deductible if incurred in the production or collection of taxable income and there must be a reasonably close connection between the legal expense and the production or collection of taxable income.
Thus, the legal costs connected with divorce, separation or support is considered nondeductible personal expenses.
Nondeductibility extends to legal fees incurred in disputes over money claims. An exception to the nondeductibility rule is that the part of legal fees attributable to producing taxable alimony is deductible by the recipient of the alimony. The attorney should stipulate what part of the fee relates to alimony to ensure a deduction for the alimony recipient.
When related to the production of taxable alimony, the legal fees are deducted as a miscellaneous itemized deduction subject to the 2% of adjusted gross income (AGI) limits, which means the taxpayer deducting the expense must itemize his or her deductions and can only deduct the amount of total miscellaneous expenses that exceeds 2% of his or her income (AGI). These expenses are not deductible at all for the alternative minimum tax (AMT) computation.
Children – The tax code provides a number of tax benefits related to children. When couples with children become divorced, the tax code specifies who benefits from those tax advantages.
Child Support - The financial responsibility to support their children lies with divorced parents in the same manner as when the child’s parents were married. Thus, if one parent is required to make child support payments to the other parent, those payments are not deductible by the parent making the payments, nor are they taxable income to the parent receiving the payments.
Tax Exemption – Each qualified child (generally those under the age of 19 or full-time students under the age of 24) represents a tax deduction in the form of a personal exemption to the parent with custody of the child. The exemption amount for 2016 is $4,050 (up from $4,000 in 2015) and, for example, creates a tax savings of $600 ($4,000 x .15) for taxpayers in the 15% tax bracket.
Custodial Parent – Often, divorcing parents will be awarded joint custody. However, tax law generally does not allow the tax benefits to be shared by both parents and instead allows only one parent to qualify for the benefits; that parent is the one with physical custody more than 50% of the year. For years, this was a difficult area with some parents who were literally clocking the amount of time day and night the child was with them in order to claim the exemption for the year.
This, in many cases, got so far out of hand that the IRS adopted regulations to deal with the issue. The IRS defines a “custodial parent” to be the parent with whom the child resides for the greater number of nights during the year. A child resides with a parent for a night if the child sleeps at the residence of that parent (whether or not the parent is present) or in the company of the parent when the child doesn’t sleep at the parent’s residence, such as when the parent and child are on vacation together. The time that the child goes to sleep is irrelevant. Provisions for special circumstances include:
• Absences of Child - If a child is temporarily absent from a parent’s home for a night, the child is treated as residing with the parent with whom the child would have resided for the night. A night is not counted for either parent if the child would not have resided with either parent for the night (for example, because a court awarded custody of the child to a third party for the period of absence) or it cannot be determined with which parent the child would have resided for the night.
• Equal Number of Nights - If a child resides with each parent for the same number of nights, then the parent with the higher AGI for the year is treated as the custodial parent.
• Night Spans Two Years – A night that extends over two tax years is allocated to the tax year in which the night begins. Thus, for example, a night that begins on December 31, 2016 is counted for taxable year 2016.
• Parent Works at Night – If, due to a parent’s nighttime work schedule, a child resides for a great number of days but not nights with the parent who works at night, that parent is treated as the custodial parent. On a school day, the child is treated as residing at the primary residence registered with the school.
Divorce Agreements & Decrees Don’t Trump Federal Tax Law – It is not uncommon for divorce attorneys, and sometimes the divorce courts, to specify in the divorce agreement or decree who is to claim a child’s exemption. It is important to understand that “exemption” is part of Federal tax law, and a divorce proceeding cannot trump Federal tax laws. Thus, regardless of what the divorce agreement reads, the exemption can only be claimed by the parent with custody the greater part of the year unless the custodial parent releases (in writing) the exemption to the other parent. The release can be for a single or multiple years and a custodial parent should exercise caution in executing a release, especially for more than one year. The release must be a written declaration and it must be unconditional (no strings attached such as requiring the non-custodial parent to meet support payment obligations). It must name the non-custodial parent and specify the year or years for which it is effective. If it specifies “all future years,” it is treated as specifying the first taxable year after the year in which it is executed and all subsequent years.
If the release is not made on the official IRS form, it must conform to the substance of that form, and it must be executed for the sole purpose of serving as a written declaration under this section. A court order or decree or separation agreement may not serve as a written declaration (because it has other purposes than releasing the exemption to the non-custodial parent). The IRS also will not accept a state court’s allocation of exemptions because the Internal Revenue Code, not state law, determines who may claim a child’s exemption for federal income tax purposes.
The non-custodial parent must attach a copy of the written declaration to his or her return for each year in which the child is claimed as a dependent.
Dependents and the Affordable Care Act (ACA) – The ACA imposes a penalty on a taxpayer if anyone in the taxpayer’s tax family does not have health insurance. A taxpayer’s tax family includes the taxpayer, the taxpayer’s spouse, if married and filing jointly, and anyone for whom the taxpayer claims, or could claim, a dependency exemption. Thus, in the case of divorced parents, the parent that claims the dependency exemption for their child is the one subject to the penalty. The penalty for 2015 is the greater of $325 for each uninsured adult plus $162.50 per uninsured child under 18 (not to exceed $975) or 2.0% of the family’s household income. In 2016 these amounts increase to the greater of $695 for each uninsured adult plus $347.50 per uninsured child (not to exceed $2,085) or 2.5% of the family’s household income. The parent who claims the dependent exemption is also the one who would be able to claim the premium tax credit for the the dependent’s health care coverage, if otherwise eligible, even if the other parent pays the premiums.
Last to File – Occasionally, both parents will attempt to claim the same child. This will not go unnoticed by the IRS, since they match tax ID numbers and will always discover when both parents have claimed the same child and issue a notice of tax change to the parent that filed last. Although not necessarily fair, the IRS will deny the child’s exemption for the parent who filed last and require that parent to prove entitlement to the exemption before reversing their decision.
Effect on Filing Status – For income tax purposes, a taxpayer’s marital status for the entire year is determined on the last day of the tax year. Thus, unless remarried, a divorced couple will be treated as unmarried individuals beginning in the year their divorce is final. Where there are no children or other qualified dependents, this means that starting with the year the divorce is final, the former spouses will each file a return using the “Single” status. However, if the couple has a child or children, the custodial parent, if not remarried, will qualify and benefit from the Head of Household filing status. Eligible Head of Household filers are allowed increased tax benefits. For example, the 2016 federal standard deduction, which is claimed in lieu of itemizing deductions, is $9,350 (up from $9,250 in 2015) for Head of Household vs. $6,300 in both 2015 and 2016 for Single status. Many phase-outs of various deductions and credits have higher-income thresholds for Head of Household filers than Single filers, which could result in the Head of Household filer claiming a bigger deduction or credit than a Single filer with the same income. Additionally, the ranges of income are wider for most federal tax rates for Heads of Households than for Singles.
Education Credits – Tax regulations provide that solely for education credit purposes, if a third party makes a payment directly to an eligible educational institution for a student’s qualified tuition and related expenses, the student would be treated as receiving the payment from the third party, and, in turn, paying the qualified tuition and related expenses. Furthermore, qualified tuition and related expenses paid by a student would be treated as paid by the taxpayer if the student is a claimed dependent of the taxpayer. Thus, in the case of divorced parents, the custodial parent will be able to claim the education credit even if the non-custodial parent is the one that actually pays the expense.
Example: If one divorced parent pays qualified tuition to a college for a child, but the other parent has custody of the child (and is eligible to claim the child as a dependent), the custodial parent is treated as having paid the tuition directly to the college and would be the one to claim the credit.
The regulations also provide that if a taxpayer is eligible to but does not claim a student as a dependent, only the student can claim the education credit for the student’s qualified tuition and related expenses.
Medical Expenses – Solely for the purpose of deducting medical expenses, a child of divorced parents is considered to be a dependent of both parents (so that each parent may deduct the medical expenses he or she pays for the child.)
Example – Bob and Jan are divorced and have two minor children. Jan claims the children as dependents and Bob pays their medical insurance and other medical expenses. Under the exception, because Jan claims them as dependents, Bob can claim the medical expenses that he pays.
Kiddie Tax - To prevent parents from placing investments in their children’s names to take advantage of the child’s lower tax rate, Congress many years back created what is referred to as the “Kiddie Tax.” Under the Kiddie Tax, a child’s investment income in excess of an annual floor amount, $2,100 for both 2015 and 2016 is taxed at the parent’s tax rate rather than the child’s. These rules generally apply to children under the age of 19 or those that are full-time students under the age of 24. For divorced or separated parents, the tax code provides the following rules to determine which parent’s return will be used to determine the tax rates used:
• Parents are married: If the child's parents file separate returns, the return of the parent with the greater taxable income is used.
• Parents not living together: If a child's parents are married to each other but not living together, and the parent with whom the child lives (the custodial parent) is considered unmarried (i.e.; lived apart for the last 6 months of the tax year and qualifies for the head of household filing status), the custodial parent’s return is used. If the custodial parent is not considered unmarried, the return of the parent with the greater taxable income is used.
• Parents divorced: If a child's parents are divorced or legally separated, and the parent who had custody of the child for the greater part of the year (the custodial parent) has not remarried, the return of the custodial parent is used.
• Custodial parent remarried: If the custodial parent has remarried, the stepparent (rather than the noncustodial parent) is treated as the child's other parent. Therefore, if the custodial parent and the stepparent file a joint return, that joint return – and not the return of the noncustodial parent – is used.
Filing Status – The marital status of a husband and wife is terminated when the couple is legally separated under a decree of divorce or of separate maintenance. An interlocutory (temporary) decree of divorce doesn't end a marriage until the decree becomes final. A couple living under a legal separation agreement but without any court decree isn't legally separated for tax purposes, because such an agreement could be terminated by the parties upon reconciliation and resumption of cohabitation.
The following are filing options for the various stages of divorce:
Divorce is Final - Once divorced and assuming that they do not remarry, taxpayers will file their returns individually. That generally means they will file as single taxpayers, or if they are the custodial parent of a child, they may qualify to file as Head of Household (see below).
Separated but Divorce Not Final - Taxpayers who are in the process of a divorce but the divorce is not final by the end of the year have the following filing options:
• File Jointly – When taxpayers file jointly, they become jointly and separately liable for the tax on the return. This may not be an appropriate filing status where there is an adversarial divorce action, since the refund or tax liability will be a joint one. The IRS will issue a refund check in the joint names and will generally go after the taxpayer with the ability to pay where there is an unpaid tax liability on the original return or a subsequent audit or adjustment. In addition, once the joint return is filed, it cannot be amended to another filing status after the due date of the original return.
• File Separately – Taxpayers have the option to file individually using the Married Separate filing status (or possibly the Head of Household status – see below), in which case they would file using their own separate income and deductions. However, determining one’s separate income and deductions can quickly become complicated for a number of reasons, such as the couple has children where one only parent can claim the deduction or the taxpayers reside in a community property state and they must split their income earned prior to separation and include their own income after separation. If one spouse itemizes, both must itemize, possibly creating a hardship for the one who would otherwise benefit from using the standard deduction. Unlike filing a joint return, where the taxpayers generally are locked into the married joint status, they can later change their filing status by amending the two married separate status returns to one return filing as Married Joint, if the change is made within three years from the unextended due date of the original return.
A number of tax benefits and provisions are not allowed to be claimed when the Married Separate status is used and the spouses have lived together at any time during the year. These unavailable items include education credits, deducting student loan interest, the adoption credit and exclusion of employer-provided adoption benefits, and deducting qualified higher education expenses (if available for that tax year). Certain income floors and calculations of phase-outs also discriminate against Married Separate filers, including the computation of the amount of Social Security benefits that are taxable.
• Head of Household – Generally, only unmarried individuals may qualify to use the Head of Household filing status. However, a married taxpayer is considered to be unmarried and may use the more beneficial Head of Household status as an alternative to filing Married Separate. To qualify, the taxpayer must live apart from their spouse at least the last six months of the year and pay more than one-half of the cost of maintaining as his or her home a household which is the principal place of abode for more than one-half the year of a child, stepchild or eligible foster child for whom the taxpayer may claim a dependency exemption. A nondependent child will qualify a taxpayer for Head of Household only if the taxpayer gave written consent to allow the dependency to the non-custodial parent.
Marriage Annulled – If a marriage is legally annulled, taxpayers will file as if never married. Returns that were jointly filed prior to the annulment and still open by the statute of limitations should be amended.
Allocation of Jointly Paid Estimated Tax Payments – When filing separate tax returns after making joint estimated tax payments the IRS provides the following rules:
• Spouses Agree Upon Allocation of Payments: One spouse can claim all of the estimated tax paid and the other none, or they can divide it in any other way they agree on.
• Spouses Cannot Agree Upon Allocation of payments: They must divide the payments in proportion to each spouse's individual tax as shown on their separate returns for the year.
Example - James and Evelyn Brown made joint estimated tax payments totaling $3,000. They file separate returns and cannot agree on how to divide estimates. James' tax is $4,000 and Evelyn's is $1,000.
James’ share = 4,000/5,000 x 3,000 = $2,400
Evelyn’s share = 1,000/5000 x 3,000 =$ 600
Property Settlements – When married couples divorce, they must divide up their property between themselves. Many mistakenly think that this results in a sale or purchase of jointly-owned property, which is not the case. No gain or loss is recognized when property is transferred between spouses during marriage. This rule applies also to transfers between former spouses if “incident to a divorce.” A transfer is considered incident to a divorce if it occurs within one year after a marriage ends, or is related to the ending of a marriage (i.e., occurs within 6 years after a marriage ends and the transfer is made under a divorce or separation agreement). A transfer which occurs later than 6 years after a marriage ends can be considered incident to a divorce if the taxpayer can show that legal factors prevented earlier transfer of the property.
Tax Basis of Transferred Property – Knowing the basis of assets such as stock and real estate is necessary to determine gain or loss when the property is sold, as well as for other tax issues, such as computing depreciation of business property. In its simplest form, basis is the price paid to acquire the property, but it can be more complicated when events have occurred that may have increased or decreased the basis. Examples of such events are stock splits or mergers and improvements made to real property. This modified basis is termed the adjusted basis. The basis of the property received in a transfer between spouses or former spouses is the adjusted basis the transferring spouse had in the property. In effect, the recipient spouse has received a gift of the transferred property. The bottom line is that the spouse who retains an item of property in a divorce assumes the same tax basis as the couple had when the property was jointly or separately owned, and therefore assumes the responsibility for any subsequent taxable gain or loss associated with the property when it is later disposed of. This can best be understood by the following example:
Example: Incident to a divorce, Don and Shirley are dividing up their property which consists of a home in which they have $300,000 of equity (value of $550,000 less a $250,000 mortgage). They originally paid $170,000 with $20,000 down and a $150,000 mortgage. After the home appreciated in value, they subsequently took a $100,000 equity loan on the home to purchase a car, pay off credit card debt and go on vacation. They also have a bank account worth $350,000. Shirley wants to keep the home and Don agrees. They decide that Shirley, will take the home ($300,000 equity) along with $25,000 of the cash. Don will take the remaining $325,000 of the bank account cash. On the surface, this would seem like an even division of jointly-owned property. However, two important issues have been overlooked.
(1) If the home was to be sold and the couple was to split the proceeds, both would have shared in the expense of the sale. Assuming a conservative sales expense of 6%, the cost of selling the home would be $33,000 ($550,000 x .06). Thus, by taking the title to the home, Shirley is assuming Don’s $16,500 (50% of $33,000) share of the sales cost based upon the value of the home at the time of the divorce.
(2) When Shirley assumes the ownership of the home, she is also assuming the tax liability for the built-in gain on the property attributed to the period of joint ownership. At the time of the divorce, the property that the couple had originally purchased for $170,000 was worth $550,000. This equates to a built-in gain, after an assumed sales cost of $33,000 of $347,000 ($550,000 - $170,000 – $33,000). Thus, even if Shirley subsequently qualifies for the home gain exclusion, she would be single and only allowed to exclude $250,000 and would end up with a $97,000 ($347,000 -$250,000) taxable gain if she sold the home.
Thus, where Don would have $325,000 of tax-free cash, Shirley’s after-tax and sales cost value of the home is significantly less.
The foregoing example demonstrates the need to consider the tax ramifications carefully to determine an equitable division of property. This can be far more complicated where the taxpayers own businesses, investments, second homes, rental property, etc. Divorce counsel will sometimes overlook the tax issues related to splitting up assets, so taxpayers should consult with a tax professional before proceeding with the allocation of jointly-owned assets.
Qualified Domestic Relations Order (QDRO) – A qualified domestic relations order is a judgment, decree, or order relating to payment of child support, alimony, or marital property rights to a spouse, former spouse, child or other dependent. The order has to contain certain specific information like the amount of the participant’s benefits to be paid to each alternate payee.
If a spouse or former spouse receives retirement benefits from a participant’s plan under a QDRO, the former spouse must report the payments just as though he/she were the plan participant. If the distribution is from a qualified plan (not including an IRA) the early distribution penalty does not apply, regardless of the alternate payee’s age. The taxability is computed by allocating the spouse/former spouse a share of the investment in the contract and figuring the taxable portion accordingly.
If the QDRO distribution is in the form of a lump sum from a pension plan, the alternate spouse payee recipient has the option of immediately paying the tax (but no 10% early withdrawal penalty if it is a qualified plan) on the distribution or deferring the tax into the future by rolling that distribution into his or her IRA or qualified plan. CAUTION: If the distribution is rolled over, then any subsequent distribution will be treated as if they were distributions from the spouse’s own IRA or qualified plan and will be subject to the pre-age 59-½ 10% early withdrawal penalty, unless other exceptions apply. Thus, the recipient of a QDRO distribution who is under age 59-½ and considering rolling the distribution over should carefully consider their pre-59-½ cash needs before executing a rollover. Under such circumstances, you are strongly urged to contact this office to determine in advance the tax implications of both options; also keep in mind that rollovers must be executed within 60 days of receiving the distribution.
If one spouse’s IRA is transferred to the other spouse under the terms of a divorce or separation agreement (not a QDRO), the transfer is not taxable to either spouse. Since the transfer isn’t taxable, the 10% early distribution penalty won’t apply. However, when the receiving spouse takes a distribution from the transferred IRA, it will be taxable and may be subject to the 10% early withdrawal penalty, depending on that spouse’s age and whether any exceptions to the early distribution penalty apply.
Primary Residence – Although the taxpayers’ primary residence will generally be included as part of the divorce property settlement discussed above, there are a number of special tax issues relating to a home:
Home Gain Exclusion – The tax code permits a taxpayer to exclude up to $250,000 of gain from the sale of the taxpayer’s primary residence provided the taxpayer owned and used the home as their primary residence for two of the prior five years, counting back from the sale date. Married taxpayers can exclude up to $500,000 if either meets the two-out-of-five year ownership requirement and both meet the two-out-of-five year use requirement. Under current rules, the gain that is excludable may be less than $250,000/$500,000 if the home has been used after 2008 as other than a principal residence, such as a vacation home, rental or for other non-qualified use. The exclusion will be limited to the amount of gain not allocated to the non-qualified use period. If your home falls into this category, please contact this office for additional information.
Sold After Division of Property - Divorcing taxpayers should take caution; since their marital status is determined on the last day of the tax year and the home has been transferred to single ownership, the $500,000 exclusion would no longer apply and the exclusion would be limited to $250,000 if sold by a spouse after the division of property. If the home is used as other than a personal residence, the reduced exclusion available to the seller should be taken into account when property divisions are negotiated.
Sold After Divorce But Still Owned By Both - If the home continues to be jointly owned and is sold after the divorce each spouse, provided that spouse separately meets the two-out-of-five year use and ownership requirement, would be qualified for the $250,000 gain exclusion. Thus, if both met the ownership and use requirement, they could exclude up to $500,000 of gain. But see above if the residence has not always been used solely as a principal residence since 2009.
Sold Before Meeting the Two-Out-of-Five Year Requirements – Tax law provides that taxpayers may qualify for prorated gain exclusion where they do not meet the two-out-of-five year use and ownership requirements and the sale was the result of “unforeseen” circumstances. As an example of a prorated exclusion, a taxpayer has a qualified unforeseen circumstance and only owned and used the home for 18 months. The single taxpayer would be qualified for a gain exclusion of $187,500 (18/24 x $250,000). The tax regulations include a number of safe harbor events that qualify as unforeseen circumstances and among them is a qualified individual's divorce or legal separation under a decree of divorce or separate maintenance.
Transfers Related to Divorce – Where an individual holds property transferred between spouses incident to divorce, the period the individual owns the property includes the period the transferor owned the property. However, the period that the transferor spouse or former spouse used the property is not included in the period that the individual used the property. Thus, a transferee spouse would still have to satisfy the use requirement in order to qualify for the exclusion.
Sale After Ex-spouse Retains Property for Some Period of Time – Frequently, as part of the divorce, a wife or husband (we’ll call them the “in-spouse”) will be granted the use of the home for a specific period of time, usually until children reach maturity. Under these circumstances, the other spouse (we’ll call them the out-spouse) is denied the ability to sell the home and avail themselves of the home gain exclusion. When the home is finally sold, usually some years later, the “out-spouse” would no longer meet the two-out-of-the-last-five years use requirement. A special provision of the tax regulations allows the “out-spouse” to treat the in-spouse’s use of the home as their own, making the home sale exclusion available to the “out-spouse” when the “in-spouse” finally sells the home, provided the “out-spouse” has not taken an exclusion on another home in the prior two years.
First-Time Homebuyer Credit Repayment – For a home purchased after April 8, 2008 and before January 1, 2009 by a qualified first-time homebuyer, the homebuyer may have claimed a refundable tax credit of the lesser of 10% of the purchase price or $7,500. This credit was, in reality, an interest-free loan that had to be paid back to the federal government over 15 years. Taxpayers who took the credit should be aware that in the case of a transfer of the residence to a spouse or to a former spouse incident to a divorce, the credit is not paid back at the time of transfer. Instead, the liability to repay the credit accompanies the home and the transferee spouse (and not the transferor spouse) will be responsible for any future repayments. This future liability should be taken into consideration when the couple’s property division is being negotiated.
Spousal Buy-Out Debt – Generally a taxpayer can only deduct the interest paid on up to $1,000,000 of home acquisition debt and $100,000 of equity debt. To the extent a taxpayer is subject to the alternative minimum tax (AMT) the equity debt interest provides no tax benefit. Generally taxpayers gain the most tax advantage from having acquisition debt interest. Acquisition debt is defined as debt used to acquire or substantially improve the taxpayer’s primary or second residence. There is a special rule that allows the spouse who retains the couple’s home, and incurs debt secured by the home to buy out the former spouse’s interest in the home, to treat that debt as acquisition debt (up to the $1 million limit) and retain the tax benefits of acquisition debt.
Alimony - Alimony is the term used for payments to a separated or ex-spouse as part of a divorce or separation agreement. The payments are generally taxable to the recipient and tax-deductible by the payer, but are not treated as alimony if the spouses file a joint return with each other. However, because of taxpayer attempts to disguise property settlements and child support as alimony, the tax code includes a stringent definition of alimony. There is one set of rules for defining alimony under decrees and agreements made before 1985 and another set of rules currently in effect. Since this article is dealing with current divorce issues only, the current rules are discussed. For information regarding pre-1985 alimony, please call this office.
Definition of Alimony – To be classified as alimony, payments must meet six conditions. Thus, the payments:
1. Must be in cash, paid to the spouse, ex-spouse or a third party on behalf of a spouse or ex-spouse.
2. Must be required by a decree or instrument incident to divorce, a written separation agreement, or a support decree. Thus, voluntary payments are not treated as alimony.
3. Cannot be designated as child support.
4. Are valid alimony only if the taxpayers live apart after the decree. Spouses who share the same household can’t qualify for alimony deductions. This is true even if the spouses live separately within a dwelling unit.
5. Must end on the death of the payee.
6. Cannot be contingent on the status of a child (that is, any amount that is discontinued when a child reaches 18, moves away, etc., is not alimony).
Payments May Be Designated as Not Alimony - Divorcing spouses can designate that otherwise qualifying payments are not alimony. This is done by including a provision in the divorce or separation instrument that states the payments are not deductible as alimony by the payer and are excludable from the recipient spouse's income. Both spouses must sign the written statement that makes this designation, and the spouse who receives the alimony and excludes it from income must attach a copy of the instrument designating the payments as not alimony to his or her return. The copy must be attached each year the designation applies.
Alimony Recapture- To further prevent property settlements from being disguised as alimony, the tax code also includes what is referred to as alimony recapture, which prevents excess front-loading of alimony payments. Under these rules, which are in effect for the first three post-separation years, alimony recapture may apply when the payments made in the first two post-separation years exceed $15,000. The excess amounts are determined in the third post-separation year, and any excess becomes taxable to the payer. The computation of the excess amount is rather complicated and this office should be contacted if front-loading of alimony is being considered. The recapture rules do not apply if: either spouse dies, the alimony recipient remarries within certain time limits, the payments made are “temporary support payments,” or the payments fluctuate due to conditions beyond the payer’s control because of a continuing liability to pay, for at least 3 years, a fixed part of business income.
Both spouses should exercise care in reporting the correct amounts of alimony received and the amounts of alimony paid. The IRS requires the payer to include both the amount paid and the recipient’s taxpayer ID number on his or her tax return and will match that to the alimony reported as income by the recipient. This matching generally occurs one or two years after the tax returns are filed and, in addition to underpaid tax, substantial penalties and interest can accrue where incorrect amounts are reported.
Alimony & IRA Contributions – Contributions to IRA accounts is limited to the extent a taxpayer has received compensation. Most consider compensation to only include wages, commissions and income from personal services. However, in addition to those, alimony is treated as compensation for purposes of making an IRA contribution (either Traditional or Roth) if the taxpayer otherwise qualifies for an IRA contribution.
Child Support – Child support is not alimony and is not a deductible expense. To keep taxpayers from disguising child support payments as alimony, the definition of alimony specifically states that alimony cannot be designated as child support and cannot be contingent on the status of a child (that is, any amount that is discontinued when a child reaches 18, moves away, etc., is not alimony).