Alimony can be substantial and, historically, the payor has relied on tax deductions to mitigate some of the financial burden. While the payor received a tax deduction, the recipient was then taxed on the amount of alimony received. However, with the new Tax Cuts and Jobs Act of 2017 (TCJA), alimony payments from divorces and agreements settled after 2018 are not deductible for the payor nor taxable to the recipient. Read on to learn how the passage of the TCJA changed how new alimony payments are treated, whether you are the payor or the recipient.
While tax treatment of alimony payments has essentially remained the same since the 1940s, the passage of the TCJA comes with a myriad of changes to the tax code. One significant change is the treatment of new divorce agreements and alimony payments, by both the recipient and the payor, for federal tax purposes.
Alimony is any payment received by or on behalf of the spouse of the payor under a separation agreement. Under previous law, these payments were deductible by the payor and were taxable to the recipient. The payor could deduct alimony payments from their gross income for federal tax purposes, giving them an “above the line” deduction, which allows the payor to deduct the payments regardless if they itemized their deductions on their return or not. The recipient would then report the alimony as part of their taxable income. In order for payments to be considered alimony the payment must follow certain criteria. The law currently states that alimony must be paid in cash or a cash equivalent, the two parties cannot be living in the same household, and the payments cannot be classified as child support.
When lawmakers were drafting the TCJA, they saw that the previous treatment of alimony payments led to a tax rate discrepancy, as the presumably higher income payor was receiving a tax deduction at a higher tax rate while the recipient was paying tax at a lower tax rate. When alimony payments were deductible to the payor and taxable to the recipient, tax was factored into the amount of alimony agreed upon. Alimony payments were calculated taking into account the deduction while still providing the recipient with the intended support.
With the passage of the TCJA, alimony is now treated differently for divorce agreements executed after December 31, 2018. Alimony is no longer deductible from gross income for the payor, and the recipient no longer needs to report it in his/her taxable income.
Members of the American Bar Association predict that with the elimination of these tax treatments for alimony agreements moving forward, the amount of alimony agreed upon will go down. This decrease will account for the lack of benefit for the payor and the lack of tax paid by the recipient. This results in an approximately equal economic effect for both parties under the TCJA as they would have experienced under pre-TCJA law.
The good news is that any alimony derived from a divorce instrument made prior to December 31, 2018 is still subject to the pre-TCJA tax treatment and has not changed. This means that if you already have an alimony agreement in place, the treatment of your payments will be grandfathered in, and the new tax treatment will not be applicable.
The only caveat to this treatment applies to modifications of a previously existing instrument. The TCJA treatment of alimony will apply to divorce instruments that are modified after December 31, 2018, only if the modification specifically states that the TCJA treatment applies.
If a modification to the alimony agreement occurs, the American Bar Association is recommending that the tax treatment under the modification is expressly stated as to whether (or not) the new tax law applies, and to not leave this up to interpretation.
The ABA also suggests alternatives to alimony payments, such as transferring retirement assets at pre-tax values as part of a property settlement or offsetting the present value of alimony with other marital assets.
It is important to note that California does not currently conform to these federal law changes. Therefore, regardless of when your divorce instrument was implemented, alimony will still remain deductible to the payor and taxable to the recipient for California tax purposes.
If you have any questions regarding these changes or any other tax matters, please do not hesitate to contact your L&B professional at (858) 558 – 9200.