"Regardless of what is in the final divorce agreement or judgment, divorced individuals need to be aware of how the IRS will treat their alimony payments. Simply agreeing on how to treat the alimony payments in the divorce agreement is not enough."
March 3, 2014
Regardless of what is in the final divorce agreement or judgment, divorced individuals need to be aware of how the IRS will treat their alimony payments. Simply agreeing on how to treat the alimony payments in the divorce agreement is not enough. The IRS will enforce the tax code provisions on these matters regardless of the parties' agreement. Alimony may be deducted from the paying party's income in certain circumstances. If those circumstances are not met and the payer deducts the alimony from his or her income, then the IRS will assess the back taxes, interest and penalties.
There are a few basic rules that apply to all individuals making alimony payments. Alimony is not deductible if the parties are living together in the same household. Only cash payments may be utilized for the purposes of a tax deductible alimony payment. For example, a taxpayer cannot deduct the value of a vacation home a former spouse is allowed to use. Lump sum alimony payments are generally not tax deductible. Alimony can be payments made to a third party if it is being made for the benefit of the recipient spouse for medical expenses, housing costs, taxes, tuition, etc. These are the first threshold steps to deciding if alimony payments can be deducted.
The next major question to be considerd is if the alimony payments decrease during the first three years of the alimony obligation. If the payments decrease in excess of what the tax code allows, then the IRS will recapture the deducted alimony payments as income and assess the back tax, penalties and interest against the deducting taxpayer. The general rule is that income will be recaptured if the amount paid in the third year decreases by more than $15,000 from the second year or the alimony paid in the second and third year decreased significantly from the alimony paid in the first year. There are a fex exceptions to the recapture rule. Decreases due to the death or re-marriage of a spouse will not trigger recapture nor will decreases due to fluctuating payments not within the control of the payer spouse. It is important to verify that there will not be a recapture of the alimony payments prior to taking the deduction. Only a $1,500 recapture could lead to an additional $450 tax plus interest and penalties.
Another major concern to be considered prior to deducting alimony on a tax return is whether decreases in the alimony payments coincide with a contingency related to a child of the relationship. Since child support is not tax deductible, if a reduction of the alimony amount coincides with a child reaching a contingency such as a certain age, graduating, dying or marrying, then the IRS will re-characterize that portion of the alimony as child support and assess back taxes, penalties and interest on it. The window in which the IRS deems the reduction in alimony related to a child contingency can be up to a year in certain circumstances and becomes even more complicated if there are multiple children of the relationship. There is significant interest and penalties potentially at stake for making an unauthorized deduction, as the re-characterization may go back several years.
Unless a taxpayer is certain the alimony payments are deductible, he or she should consult a tax professional before filing his or her tax return. IRS publication 504 should also be consulted for additional information on tax implications for separated and divorced individuals.