December 1, 2013
When a spouse in a divorce is adverse to paying alimony, one option is to provide a property settlement that is the equivalent of all the alimony payments. This may be more palatable to the payor, even though he or she gets no tax advantage from the one-time payment. Some attorneys and payors try to “have their cake and eat it too” by recasting property settlement payments into tax-deductible alimony. This is done by front loading: a payor-spouse would pay a large amount of “alimony” for one or two years only. However alimony payments that decrease or stop during the first three years may be subject to IRS recapture rules.
Recapture is triggered when alimony steps down by more than $15,000 per year during the first 3 years. Specifically recapture occurs if (1) the amount of alimony paid in the third year plus $15,000 is less than the amount paid in the second year, or (2) when payments in the second and third year are averaged and this average plus $15,000 is less than the payments in the first year. If either of these occur then a portion of the “excess” payments must be included in the payor-spouse's income in the third post-separation year. The payee-spouse, who previously included the payments in income, is entitled to a corresponding deduction in the third post-separation year.
The formula for calculating the recaptured amount of payments is not always as simple as calculating the payments above $15,000. As the example below shows the penalty can be quite costly.
Example: Stephen and Jessica agreed that Stephen would pay Jessica maintenance for two years. Stephen wants to buy Jessica a new car and wants to deduct its cost as maintenance. To satisfy the “three year” provision, he has agreed to pay $1,000 in the third year.
Here’s what it looks like:
1st year $60,000 ($30,000 basic maintenance plus cost of car)
2nd year $30,000
3rd year $ 1,000
Stephen will have to recapture $51,500 into income in the third year and Jessica will receive a deduction from her gross income in the same amount.
Recapture always occurs in the 3rd year, after applying the two criteria outlined above.
Example: Howard and Jane have had a contentious divorce. Howard wants to sever all ties with her as soon as possible. He has proposed to pay Jane a single lump-sum payment of $50,000 as alimony in 2013. No further payments are required under the terms of their divorce decree. The tax consequences to Howard and Jane are as follows:
2013: James may deduct and Julie will pay taxes on the lump-sum payment of $50,000. There is no recapture.
2014: There are no tax consequences to either Howard or Jane and there is no recapture.
2015: Since 2015 is the third post-separation year, $35,000 is recaptured. The amount recaptured is required to be included within Howard’ gross income and is deductible by Jane.
Trying to disguise a large property settlement as alimony won’t pass IRS scrutiny. And even if the intention is honest and the parties are not trying to pass off a transfer of property as alimony, the IRS may see it that way. To avoid the possibility of recapture, make sure alimony lasts for at least 3 years and does not decrease by more than $15,000 between each of these years.