Divorce can be taxing — in more ways than one. There’s no doubt that dividing up financial and physical assets, negotiating spousal support, making arrangements for the care and support of children, dealing with the family home, and making the myriad other decisions involved in splitting up a marital partnership can be physically and emotionally draining. However, as tax professionals are well aware, each and every one of those decisions can have significant tax consequences that must be factored into the equation.
And starting in 2019, that equation changes dramatically. Moreover, that’s true not just for taxpayers who are currently in the throes of a divorce, but also for taxpayers who have been divorced for years and even for those who are happily married. For example, a divorced couple may have made decisions about spousal support and other financial matters based on tax assumptions that no longer apply. Similarly, a happily married couple may have entered into a prenuptial agreement that no longer makes “tax sense.”
Key Tax Change for Tax Year 2019
Under longstanding tax law rules, alimony has been deductible above-the-line by the payor and included in income by the payee. However, starting in 2019, the 2017 Tax Cuts and Jobs Act reverses the rules: Effective for divorce or separation agreements executed after 2018, alimony is nondeductible by the payor and is not included in income by the payee [IRC Secs. 71, 215 repealed].
The key — and most obvious— impact of the new alimony rules is to increase the overall tax bite on income used to pay alimony. Because alimony is generally payable by the higher-income spouse, the deduction/inclusion rule of prior law generally shifted income from the payor spouse’s high tax bracket to the payee spouse’s lower tax bracket, resulting in net overall tax savings.
Jane and John Doe divorced in 2018. Under their divorce agreement, John must pay Jane $50,000 each year in alimony. Since the Doe’s divorced before 2019, the alimony payments are deductible by John and income to Jane. John earns a hefty salary that puts him in the top 37 percent bracket for 2019, while Jane’s income puts her in the 22 percent bracket. Therefore, the alimony deduction saves John $18,500 in taxes, while costing Jane $11,000.
Assume the same facts as Example 1, except the Does divorce in 2019. Under the new rules, the $50,000 is not deductible by John. Therefore, he will pay $18,500 of tax on the income used to make the payments. On the other hand, since the $50,000 in alimony is not includable in Jane’s income, her tax cost will be $0.
Bottom line: The shifting of the tax burden on the alimony payments from Jane to Joe results in a net tax increase of $7,500.
Relative tax rates don’t tell the whole story, however. While the alimony deduction/inclusion rule remains in effect for couples who divorced prior to 2019, other changes made by tax reform the 2017 Tax Cuts and Jobs Act may alter the bottom line. For example, the spouse’s relative tax rates may have shifted under the new law’s tax rate schedules. Moreover, alimony that is included in income by the payee spouse may be sheltered from income by the increased standard deduction.
In addition, by shifting alimony income from the payee to the payor spouse, the new law increases the adjusted gross income (AGI) of the payor and correspondingly decreases the AGI of the payee. This, in turn, may affect the tax deductions and credits available to the former spouses.
Key point: Clearly, newly divorcing taxpayers will need to bone up on this new tax math. However, couples whose current divorce settlements were based on prior tax law assumptions may want to renegotiate — especially if the divorce was an amicable one. And couples with prenuptial agreements should consider reviewing them now to avoid disagreements down the road.
Couples who choose to renegotiate pre-2019 divorce agreement have a choice: They can stick with the old rules or switch to the new. The law provides that the repeal of the deduction for alimony paid and income exclusion for alimony received will apply to a divorce or separation agreement that is modified after Dec. 31, 2018 — but only if the modification expressly provides that the new rules apply to the modification.