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Taxes by Bill Bischoff (Author Archive)
Setting Up Tax-Deductible Alimony Payments
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WHEN A MARRIAGE disintegrates, payments to the ex might have to be made. However, those who face this unhappy fate may get some relief: You can deduct payments that meet the tax-law definition of alimony. On the flip side, alimony payments that you deduct must be reported as taxable income on your ex's Form 1040 — overall a fair enough exchange.
The difficult part is meeting the tax-law requirements for deductible alimony. If you fail to set your payments up properly before signing off on the divorce papers, it may be too late to salvage any deductions. Here's what you need to know to get the best results:
Requirements for Deductible Alimony
For a payment to qualify as deductible alimony for federal income tax purposes, seven requirements must be met:1. The payment must be made as a result of a written divorce or separation agreement.
2. The payment must be made to or on behalf of your ex. Payments to third parties, such as attorneys and mortgage lenders, are OK if they're made on behalf of your ex pursuant to the divorce or separation agreement or at the written request of your ex.
3. The divorce or separation agreement cannot state that the payment is not alimony.
4. After you are divorced or legally separated (meaning after you're considered divorced for tax purposes), you and your ex cannot live in the same household or file a joint Form 1040.
5. The payment must be in cash or cash equivalent.
6. The payment cannot be considered child support (more on that later).
7. Your obligation to make payments (other than delinquent amounts) must cease if your ex dies.
Regardless of what the divorce decree might say or what you and your ex might intend, only payments that meet all of these requirements count as deductible alimony. Otherwise, payments will be treated as either part of the divorce property settlement or as child support, both of which are nondeductible for you and tax-free for your ex.
Avoiding Unintended Child Support
Any payments you make to your ex — even if they are labeled as alimony in the divorce agreement — are considered child support if they are either "fixed child support" or "deemed child support." Both types of child support are nondeductible. Here's how to determine whether your payments will fall under one of these categories:Fixed Child Support
Fixed child support simply refers to payments that are designated as child support in the divorce or separation agreement.
Deemed Child Support
Deemed child support payments are much harder to spot. Starting on Day One, payments are considered deemed child support to the extent of future payment reductions that are triggered by any of the following child-related events:
The child attains age 18, 21, or the age of majority under local law.
Death of the child.
Marriage of the child.
Completion of the child's schooling.
The child leaves the household.
The child attains a specified income level or becomes employed.
Example: Say your divorce decree requires you to pay $3,500 per month to your ex who has primary custody of your 10-year-old child. According to the decree, when the child turns 18, your monthly payment obligation will be reduced from $3,500 to $1,800. Assume the payments to your ex meet all the other tax-law requirements for deductible alimony and are even designated as deductible alimony in the divorce decree. It doesn't matter. Under the rules explained above, $1,700 of each and every monthly payment, starting on Day One, must be treated as nondeductible deemed child support. Why? Because there will be a $1,700 payment reduction when your child turns 18 in eight years. In other words, starting on Day One, you can only deduct $1,800 per month as alimony ($3,500 - $1,700 of deemed child support). The remaining $1,700 of each and every monthly payment, starting on Day One, is categorized as nondeductible deemed child support. This may not seem fair to you, but your ex will be pleased because he or she will only have to report $1,800 a month as income on his or her Form 1040.To make things even more complicated, payments that are reduced within six months before or after a child reaches age 18, 21, or the local age of majority are also treated as deemed child support. Finally, when there are two or more children and payments are to be reduced on two or more dates, it's even more likely that payments you thought were deductible alimony must be treated as nondeductible deemed child support.
Keep in mind that deemed child support rules are extremely complicated, and they represent a nasty trap for unwary taxpayers. For additional information on what constitutes deemed child support, see IRS Publication 504 (Divorced or Separated Individuals).
Avoiding Alimony Recapture
Let's assume you've successfully cleared all the hurdles explained so far. Great, but there's still one more to go: the so-called alimony recapture rule. Under this rule, you must determine whether your deductible alimony payments were excessively "front-loaded" during the first two calendar years. If they were, you must "recapture," or report as taxable income, some of the deductions you claimed in those years. After figuring the amount of alimony recapture, you must then report that amount as income on your Form 1040 for the third year. Correspondingly, your ex gets to claim a deduction for the recaptured amount on her return for that year.The somewhat good news is that only payments that you deduct as alimony in the first two years are subject to the alimony recapture rule. However, payments in the third year must be taken into account when determining whether you'll get hit by the recapture rule. Payments in the fourth year and beyond have no impact whatsoever on the recapture calculation.
Rather than go into a confusing explanation of precisely when amounts will or will not run afoul of the alimony recapture rule, see our handy alimony recapture calculator.
The Bottom Line
Just labeling payments deductible alimony in your divorce papers won't get the job done. Instead, you'll need to jump through some tax-law hoops to secure any write-offs. Plus, you'll need to spread out your payments in order to avoid the alimony recapture rule. Sadly, you cannot necessarily rely on your trusty divorce attorney to guide you through the process. Many otherwise-competent divorce lawyers are simply not up to speed on the tax rules. Instead, hire a tax professional with strong experience in divorce-related tax matters, especially when significant dollars are at stake.
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