Alimony and Separate Maintenance Payments

The tax treatment of alimony payments changed significantly with the repeal of Section 71 in 2017. This guide explains the current tax treatment of alimony, implications for payors and recipients, and what taxpayers need to know.

What is Alimony?

Alimony refers to the financial support that one spouse may be required to pay to the other following a divorce or separation. The primary purpose of alimony is to provide financial assistance to a lower-earning or non-working spouse, helping them maintain a standard of living similar to what they had during the marriage.

Types of Alimony

1. Temporary Alimony: This is awarded during the divorce proceedings and is intended to support the lower-earning spouse until the divorce is finalized.
2. Rehabilitative Alimony: Aimed at helping the recipient gain the necessary skills or education to become self-sufficient. This type of alimony is typically awarded for a specific period.
3. Permanent Alimony: This may be awarded in long-term marriages and is intended to provide for the recipient indefinitely or until a significant change in circumstances occurs.
4. Lump-Sum Alimony: Instead of periodic payments, this involves a one-time payment that settles the alimony obligation.

The Tax Treatment of Alimony: Pre-2019 Changes

Before the tax reforms enacted in 2017, alimony payments had specific tax implications under IRC Section 71. Here’s how it worked:

For the Payor

• Alimony payments were tax-deductible. This means that the person paying alimony could deduct the amount paid from their taxable income, which helped reduce their overall tax liability.

For the Recipient

• The recipient of alimony was required to include the payments as taxable income on their tax return. This meant that they would pay taxes on the amount they received.

This arrangement was designed to balance the financial burden between the payer and the recipient, ensuring that both parties had a fair tax treatment.

The Repeal of IRC Section 71

With the passing of the Tax Cuts and Jobs Act (TCJA) in December 2017, IRC Section 71 was effectively repealed for divorce or separation agreements executed after December 31, 2018. Below are the key changes that came into effect:

New Tax Treatment for Alimony

1. For Divorce Agreements Executed After December 31, 2018:

   • Payor: Alimony payments are no longer tax-deductible. Individuals who pay alimony cannot reduce their taxable income by the amount they pay.
   • Recipient: Alimony payments are not included in the recipient's taxable income. This means that the recipient does not owe taxes on the alimony they receive.

2. For Agreements Executed Before December 31, 2018:

   • The old rules continue to apply as long as the divorce agreement or separation instrument remains unchanged. If modifications are made after this date, the new tax treatment will apply if the modification explicitly states so.

Practical Implications of the Tax Changes

The repeal of IRC Section 71 has significant implications for both spouses involved in a divorce. Here’s a closer look at how these changes can affect taxpayers:

Financial Planning for the Payor

• Increased Financial Burden: Without the ability to deduct alimony payments, the effective cost of alimony may increase for the payor. This could lead to budgeting challenges, especially for those who relied on the tax deduction to manage their finances.

• Negotiation Considerations: When negotiating divorce settlements, payors may seek to adjust the amount of alimony to compensate for the loss of the tax deduction.

Financial Planning for the Recipient

• Tax-Free Income: Recipients may find themselves in a more favorable position since they do not have to report alimony as taxable income. This can provide a more stable financial footing.

• Impact on Other Benefits: Recipients should be aware that while alimony is not taxable, it may still be considered in determining eligibility for certain government benefits. Understanding how alimony interacts with these programs is essential.

Common Scenarios and Examples

Scenario 1: Divorce Agreement Executed Before 2019

A couple finalizes their divorce in 2018. According to their agreement, the payor is required to pay $2,000 per month in alimony.

• Tax Outcome:
  • The payor can deduct the $2,000 from taxable income, effectively lowering the tax bill.
  • The recipient must report the $2,000 as income on the tax return.

Scenario 2: Divorce Agreement Executed After 2019

A couple finalizes their divorce in 2020. The payor is ordered to pay $1,500 per month in alimony.

• Tax Outcome:
  • The payor cannot deduct the $1,500 from taxable income.
  • The recipient does not have to report the $1,500 as income.

Scenario 3: Modification of Agreement

A couple divorces in 2017, and the recipient receives $3,000 per month in alimony. In 2024, they modify their agreement to increase the alimony to $3,500 due to changing financial circumstances.

• Tax Outcome:
  • The original agreement's tax treatment applies to the first $3,000, meaning the payor can deduct it and the recipient must report it.
  • The additional $500 is subject to the new tax rules, meaning the payor cannot deduct it and the recipient does not report it.

Summary

The repeal of Section 71 changed alimony tax treatment for agreements executed after December 31, 2018. Payors can no longer deduct alimony payments, and recipients no longer include them in taxable income. Agreements executed before 2019 generally retain the old tax treatment unless modified.

Practical Tips for Taxpayers

1. Consult a Tax Professional: Given the complexities surrounding alimony and tax implications, it is advisable to seek the guidance of a tax advisor or financial planner who can provide personalized advice based on your unique situation.

2. Review Your Divorce Agreement: If you are in the process of divorce or considering a modification, pay close attention to the language in your agreement regarding alimony. This can have lasting tax implications.

3. Be Aware of State Laws: Alimony laws vary by state. Understanding your state's specific regulations can help you navigate potential complications.

4. Consider Long-Term Financial Planning: Whether you are paying or receiving alimony, consider how these payments affect your overall financial health and future planning, particularly regarding retirement savings and investments.

By staying informed and proactive, taxpayers can navigate the changes in alimony tax treatment and make decisions that best support their financial well-being.