If you are divorced or in the process of divorcing, it is imperative to understand how the Tax Cuts and Jobs Act affects the tax treatment of alimony. For most couples, the tax cost of divorce will go up next year.

What is changing?

Under current rules, a taxpayer who pays alimony is entitled to a deduction for payments made during the year. The deduction is above-the-line, which is a big advantage, because there is no need to itemize. The payments are included in the recipient spouse's gross income.

The TCJA essentially reverses the tax treatment of alimony, effective for divorce or separation instruments executed after 2018. In other words, starting next year, new alimony arrangements will no longer be deductible by the payer and will be excluded from the recipient's gross income.

Existing divorce or separation instruments, including those executed during the remainder of 2018, are not affected. Current rules apply even if an instrument is modified after 2018 (unless the modification expressly provides that TCJA rules apply).

What is the impact?

The TCJA will likely cause alimony awards to decrease for post-2018 divorces or separations. Paying spouses will argue that, without the benefit of the alimony deduction, they cannot afford to pay as much as they could under current rules. The ability of recipients to exclude alimony from income will at least partially offset the decrease, but many recipients will be worse off under the new rules.

For example, let's say John and Lori are divorcing in 2018. Lori is in the 35% federal income tax bracket and John is a stay-at-home dad who cares for the couple's two children. The court orders Lori to pay John $100,000 per year in alimony. Lori is entitled to deduct the payments, so the after-tax cost to her is $65,000. Presuming John qualifies to file as head of household and the children qualify for the full child tax credit, John’s federal tax on the alimony payments is approximately $8,600, leaving him with $91,400 in after-tax income.

Suppose, instead, that John and Lori divorce in 2019. Lori argues that, without the alimony deduction, the most she can afford to pay is $65,000, and the court agrees. The payments are tax-free to John, but he is still left with $26,400 less than he would have received under pre-TCJA rules.

The current rules essentially shift income recognition from the paying spouse to the recipient, reducing the couple's overall tax liability (assuming the recipient is in a lower tax bracket). The new rules eliminate this tax advantage. Of course, in the event that the recipient is in a higher tax bracket than the payer (an uncommon, but not impossible situation), a couple is better off under the new rules.

What if you are already divorced?

The new rules will not affect existing divorce or separation instruments, even if they are modified after 2018. However, spouses who would benefit from the TCJA rules — because their relative income levels have changed — may voluntarily apply them if the modification expressly provides for such treatment.

Act quickly before the end of the year

If you are initiating a divorce or separation and would benefit from the alimony deduction, act quickly to ensure that it is finalized before the end of the year. If you are already divorced or separated, determine whether you would benefit by applying the new rules to your alimony payments. If you would, a modification of your divorce or separation instrument may be in order.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.