Divorce can create significant tax implications on your alimony payments.
The Internal Revenue Service (IRS) determines rules about alimony and taxes, not judges or attorneys, or language in court orders or divorce settlements.
Only alimony that is paid or received as part of a written legal separation or divorce settlement is covered for tax purposes. Anything transacted prior to or outside of a separation agreement or divorce decree is not eligible. Child support is also not taxable as income and cannot be claimed as a deduction.
If you are paying alimony it is most likely a tax deduction.
If you are receiving alimony it is most likely taxable income.
The type of alimony you are paying/receiving (lump sum alimony, periodic alimony, etc…) will determine the tax consequences for both the payor and the recipient. Further, whether the payments are deemed alimony or property division will have a bearing on how they are treated for tax purposes.
FOR THE PAYOR
If the alimony you are paying is determined to be tax deductible, you will need to consider if you and your former spouse:
- File separate returns;
- You pay in cash or by check or money order;
- The payment is received directly by your former spouse or by a third party on behalf of your former spouse for services rendered (like an attorney or a mortgage company). Third party payments must be formalized in a written document indicating that this is your former spouse’s preference and that the payment is in lieu of cash;
- The divorce decree or legal separation is silent as to whether the payment is or is not alimony;
- Your payment is not treated as child support or a property settlement;
- You and your spouse do not live in the same physical household;
- You have no liability to make payments after your former spouse has died;
Depending on your divorce settlement, alimony can include life insurance premiums you pay on policies owned by your former spouse. Alimony can also include expenses for a jointly-owned property. Half of the mortgage payments (principal and interest) may be deductible.
When claiming alimony as a tax deduction you must include your former spouse’s social security number on the form. If you don’t, you may be fined and your claim may be rejected.
FOR THE RECIPIENT
If you are receiving alimony, it most likely is considered taxable income and must be reported when you file a tax return.
The IRS will probably already know you are receiving alimony because it will have been claimed as a deduction by your former spouse. They will cross-examine the records and if you do not report this income, it can trigger an audit.
You also have to give the payor (your former spouse) your social security number. If you do not you may be assessed a fine.
Since taxes are not withheld from alimony payments you will have to plan carefully to avoid owing a tax bill on April 15th.
You will also not be able to file shorter, “EZ” tax forms. Alimony must be reported on the 1040 long form.
ALTERNATIVES TO ALIMONY
There are alternatives to alimony and each has its own tax implications. For example, some people prefer to receive all of their alimony as a one time lump payment. In this case the payment may be treated as a division of assets and therefore is not taxable for the recipient or deductible for the payor.
Another alternative to periodic alimony payments is setting up a trust. Under this arrangement, the payor transfers income generating assets or property into a trust. The income produced from this trust is then used to pay alimony. This arrangement also has different tax implications depending on how it is structured.
Don’t be surprised on April 15 with a bigger than expected tax bill or miss out on valuable tax deductions. Discuss your options in advance with divorce and tax attorneys as part of your case.