Taxation of Divorce Awards

Alimony can be deductible from income for the payor and includable in income for the payee. Alimony payments are considered ordinary income. This includes payments to a spouse or a former spouse made under a decree of separate maintenance or pendente lite (during the litigation) support. Alimony, for tax purposes, does not include amounts specifically designated as child support, but can, under some circumstances, be for the payment of property rights.

The fact that the divorce decree or marital settlement designates a payment as “alimony” or “support” or similar language, is not determinative as to whether or not it is alimony for tax purposes. Also, the intent of the parties is not a relevant factor either. To be taxable to the person receiving alimony and deductible by the person paying alimony, payments must meet the following requirements:

1. Payments must be in cash or the equivalent (e.g., check, money order). Payments may be made to third parties on behalf of the person receiving alimony. Transfer of services or property, execution of a promissory note or other debt instrument, or allowing the free or reduced cost use of property does not qualify as alimony for tax purposes.
2. Payments must be made pursuant to a written divorce or separation instrument. Voluntary payments are not considered alimony for tax purposes under the Internal Revenue Code. Qualifying divorce or separation agreements are:
   • A decree of divorce (i.e., final judgment of dissolution of marriage) or a written instrument incident to such a decree.
   • A written separation agreement. Oral agreements do not qualify.
   • Any other decree requiring a spouse to make payments for the maintenance or support of the other spouse, including all temporary relief orders.
3. The written instrument does not designate the payments as not includible in gross income for the recipient. In other words, if the parties or the court has designated in writing that the payments are not includible as gross income for the payee, then they are not alimony for tax purposes.
4. The spouses cannot be members of the same household at the time the payment is made. Physical separation within a single dwelling unit is not sufficient. There must be two separate households.
5. The liability to make payments must terminate upon the recipient’s death. A payment that is due and owing regardless of the death of the recipient is not alimony but is rather the payment of a debt, for tax purposes. There is a vehicle, known as an alimony trust, which can be used to avoid this requirement.
6. Payments specifically designated as child support are not alimony or separate maintenance payments for tax purposes. To the extent payments are reduced due to a contingency relating to a child, such as attaining a certain age, dying, marrying, or graduation from school, the payments will be classified for tax purposes as child support, and will not be alimony. Any contingency clearly associated with a child has the same effect, such as payments that terminate in the same month as a child's 18th birthday.
7. The payor and payee must not file a joint income tax return.

Alimony is not subject to withholding, so the recipient spouse should make estimated tax payments every quarter. Failure to make estimated tax payments can result in a penalty being imposed.

Alimony Recapture Rule

Alimony payors sometimes scheme to get tax treatment for property settlements using a method known as "front-loading". Large “alimony” payments are made in the first few years after divorce, and then the amount tapers off to a lower amount. The Internal Revenue Code recognizes that this is nothing more than allowing the payor party to get a tax deduction for a property transfer that they would not ordinarily be entitled to, and punishes this practice accordingly.

Excess payments of alimony or separate maintenance made in any of the first three post-separation years can trigger a recomputation of the taxes for those years, which may potentially result in additional payments and penalties. The payor can be required to include the excess amount in their gross income for tax purposes, and the payee can get a deduction for the excess amount. This is known as recapture

Recapture only applies to payments made during the first three post-separation years.

Special Rules for Temporary Alimony

Alimony paid during the pendency of the divorce litigation can be deductible from gross income for the payor and includible in gross income for the payee in the same manner as permanent alimony, as described above, with some exceptions:

1. The requirement of living in separate households is not necessary.
2. A court order, and thus pending litigation, is required.
3. Recomputation and recapture is inapplicable.

Life Insurance Awarded as Support

Sometimes parties can agree, or a court can order, that the alimony recipient owns a life insurance policy on the life of the payor. When such a policy is solely owned by the payee, premiums paid by the payor may be considered alimony payments for taxation purposes. To be deductible/includible, the premiums must also meet the other tests for alimony, and the payee must receive a current economic benefit. An economic benefit is typically not present with standard term insurance because term insurance has no current cash surrender value. On the other hand, whole life insurance policies that have a present cash surrender value do confer a current economic benefit on the owner. Such economic benefit may not be present, though, when the policy only secures the payment of alimony.

When the payor owns the policy, premium payments are not considered alimony, even if the payee is the beneficiary of the policy. Premium payments do not qualify as alimony if the payor and payee share ownership. When a trust or other third party owns the policy, the premiums are also not considered alimony for tax purposes.

Child Support

Payments for the support of minor children are not taxable to the person receiving payment, nor deductible by the parent paying child support. Payments for the support of minor children must be designated as child support by the decree, instrument, or agreement. Medical expenses paid for a minor child are deductible by the parent that pays the bills, so long as the parents are divorced, legally separated, have a written separation agreement or have lived apart for the last six months of the calendar year. The deduction is limited to medical expenses that exceed 7.5% of adjusted gross income. What qualifies as a medical expense for the purpose of the deduction is determined by the Internal Revenue Code, § 213

Property Transfers and Divisions

Any property transfer between spouses during the marriage or in a divorce is not taxable, regardless of how the spouses own the property or the reasons for the transfer. This applies to any transfer between spouses while they are married unless the transferee spouse is a nonresident alien. This rule also applies to transfers made to a former spouse of the transferor, if the transfer is "incident to a divorce", if made within one year of the date on which the marriage ceases, or "is related to the cessation of the marriage." Transfers within six (6) years of the divorce are presumed by the Internal Revenue Code to be related to the cessation of the marriage.

Such transfers between spouses are not treated as sales. The spouse transferring the property does not report any gain or loss, regardless of the type of property transferred. The spouse receiving the property is treated as having acquired the property by gift and reports no income when he or she receives the property. The person receiving the property takes a tax basis in the property equal to the property's adjusted basis in the hands of the transferor before the transfer whether the property has appreciated or depreciated in value. The transferee of the property in question is treated as having owned the property during the time the transferor did (i.e., there is "tacking" of the holding period for the transferee).

Transfers of corporate stock, partnership interests and property within a sole proprietorship between spouses and former spouses are usually not taxable under the rules described above.

If the transferor owns appreciated property with a low adjusted basis for tax purposes, he or she may wish to receive credit for equitable distribution purposes for the appreciated value while at the same time unloading the potential tax liability on the unsuspecting transferee spouse. An example would be a commercial building purchased 25 years ago for $25,000 which is now worth $150,000. The transferee is receiving an asset that, when sold, will have a tax liability (for long-term capital gains) associated with it which will reduce its net value. For this reason, and others, it is important to be aware of the tax basis of the various properties being transferred or retained when negotiating property division incident to divorce.

Capital Gains

Capital gains tax is due when you sell property for a profit. The amount of the tax depends on how long you have owned the property and what kind of property you sold.

There are two holding periods used to determine the capital gains tax due when you sell property for a profit. The first is a short term which applies to assets held for less than one year. The second is long term which applies to assets held for more than one year before they are sold.

Short term capital gains are taxed at ordinary income tax rates, in other words, at whatever tax bracket you happen to be in at the end of the year in which you sold the property. Long term capital gains are taxed at a separate rate.

Long term gains on collectible items such as art, rugs, antiques, metals, gems, stamps, and coins are taxed at 28%, regardless of what tax bracket you happen to be in.

You can exclude up to $500,000 of taxable gain on the sale of your principal residence if you meet three tests. (1) You must own the home for a minimum of two out of the five years prior to its sale. (2) You must have used the residence as your principal residence for a minimum of two out of the five years prior to its sale. (3) You must not have already sold another principal residence within two years prior to the sale.

The old rules requiring you to purchase another principal residence within two years in order to defer a capital gain have been repealed. The old rules that permitted a seller age 55 or older to exclude up to $125,000 of gain on the sale of a principal residence have also been repealed.

This is a very simplistic overview of capital gains. Because these rules are so complicated, you should consult with your tax advisor for specific advice on how these rules apply to your situation.