Each tax season in my work as a CFP, I have the unpleasant task of informing a recent divorcee that they have an unexpected and substantial tax liability. It’s a curious phenomenon that during tax preparation, the spousal support payor rarely forgets the deduction and chimes in with, “Don’t forget to include my alimony – it’s a write-off, isn’t it?” But the recipient is often “surprised” when reminded that the spousal support they received in the past year is a fully taxable event.
So, what are the conditions under which alimony is taxable to the recipient and deductible to the payor?
There are 5 essential conditions that qualify spousal support as deductible:
- Payments are made in cash, or cash equivalents.
- The settlement agreement does not say that the payment is NOT alimony.
- The payor and recipient are not living in the same residence.
- The payment is not child support.
- Payments stop at death.
Payments made to a third party can be considered deductible spousal support if they are ordered in the marital settlement agreement. These might include rent, mortgage, utilities, medical expenses and/or educational expenses.
Voluntary payments, that is, payments not ordered by a marital settlement agreement, do not qualify as spousal support, and therefore cannot be deducted.
In a previous blog, I discussed how clients often establish informal financial agreements while separated, such as funding living expenses or depositing money in bank accounts for general purposes. These payments would not be deductible.
Family support is not deductible. If your marital settlement agreement orders spousal support and child support, and you pay less than the total required, the payments apply first to child support. Any remaining amount is then considered deductible as spousal support.
Timing is Everything
Recapture rules apply if excess spousal support payments are frontloaded into the first three calendar years. If your alimony payments decrease significantly or end during the first three calendar years of the agreement, you may be required to include part of the previously deducted payments as income. This rule was designed to discourage divorcing spouses from improperly characterizing property settlement payments as spousal support.
Other reasons for a reduction or end of spousal support payments that can trigger recapture include:
- A change in your divorce or separation instrument;
- A failure to make timely payments;
- A reduction in your ability to provide support; or
- A reduction in your spouse’s support needs.
Divorce in itself is not a taxable event but many of its transactions, including spousal support, have significant tax consequences. Always see a tax professional or certified financial planner prior to finalizing your settlement agreement or when any significant life change occurs, in order to avoid an unexpected tax liability.