Recreating a tax-deductible alimony payment

May 15, 2020

In January 2019 the tax rules around alimony were changed, such that these payments are no longer tax-deductible to the payor and are not taxable to the payee. This shift has advantages and disadvantages. On the plus side, the payor no longer must worry about the somewhat complex alimony recapture rule, which prevents front-loading payments. A payor can now make large alimony payments for one or two years and then reduced payments after that without violating the IRS definition for deductibility. Or, one lump-sum payment can be made in lieu of monthly payments. And the payee does not have to declare the alimony payments as income.

The big disadvantage of the change is that the payor can no longer deduct alimony payments on his or her tax return. This means the payments have an added cost to the payor, because they have to pay federal income tax on their income first, then make alimony payments from net income.

As an example, Ted is ordered to pay Alice $1,000 per month in alimony. Under the old rules Ted would have deducted $12,000 from income and, assuming he’s in the 22% marginal tax bracket, saved himself $2,640 in taxes. The net cost to Ted of one year of alimony payments would have been $9,360 ($12,000 - $2,640). Under the new rules there is no tax deduction and in fact Ted must earn $15,384 in order to have $12,000 after taxes for alimony ($15,384 x .78 = $12,000.) The difference between the old and new rule is $6,024.

There are several ways in which the payor can create a tax deduction for the dollar amount of alimony payments. The payments themselves are not deductible, but a different tax-deductible expense is used in its place.

The first way assumes that the mortgage is in joint name or the payor’s name. In this situation the payor can make mortgage payments in lieu of alimony and take a tax-deduction for the interest (limited to half the interest if the mortgage is in joint name). If the payor still owns or co-owns the house, he can also deduct the proportionate share of property tax. For instance, Ted and Alice agree that they will co-own the house and mortgage and Alice will live there for 3 years after the divorce. Ted could pay Alice’s property taxes of $9,000 per year in lieu of $750 per month of alimony and deduct half of that on his taxes.  It’s very important to note that Ted must remain as an owner of the house, something that is not acceptable to all couples going through divorce. In addition, Ted must have enough itemized deductions (including the property tax and mortgage interest that he is paying for Alice) to exceed his standard deduction.

The other method of replacing deductible alimony is for Ted to take a loan from his 401(k) or 403(b) and give the proceeds to Alice in lieu of monthly alimony. Then Ted could use the money he was going to pay Alice to make 401(k) or 403(b) contributions instead, which are tax-deductible. This strategy works if Ted is not already maxing out his retirement plan or was going to have to stop retirement plan contributions in order to make alimony payments. Also, the interest rate on the loan must be taken into consideration as a cost of this strategy.

While neither of these strategies will work in all situations, you may have a case in which one of them could help a payor recreate some or all the lost alimony deduction. A Certified Divorce Financial Analyst can help you analyze the options.

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