Many high-net-worth couples may want to finalize their divorce agreements before the new tax law takes effect to preserve some important financial options.
By Heather L. Locus, Wealth Manager
The Tax Cuts and Jobs Act of 2017 (TCJA) enacted some of the most dramatic changes we’ve seen in decades to the tax issues impacting how divorces are settled. With an entirely new view of taxable income, it will be harder for spouses to limit the financial pain that comes with divorce.
Although much is still uncertain, it is becoming clear that many high-net-worth couples may want to move quickly in order to preserve some important financial options. Couples who finalize their divorce agreements this year have many more options since the most significant rules impacting divorce go into effect on New Year’s Day 2019. Here’s why.
How the New Tax Law Could Help – or Hurt – High-Net-Worth Divorce Cases
2019 is a Pivotal Year for Alimony
Agreements executed in 2018 will retain the default of alimony being deductible by the payor and included as taxable income to the recipient – which has been the case since 1942. If taxpayers have a pre-2019 divorce or separation decree and they legally modify it, the new rules do not apply unless the modification expressly provides that the TCJA applies.
Therefore, existing divorced couples and those who prove-up in 2018 will be able to maintain the current deductibility of alimony/maintenance after 2019 and for as long as they pay it. Depending on what your clients want, you may be faced with a heavy workload to finalize divorces before the end of 2018 – or to defend delaying a divorce until 2019 when the new tax law takes effect.
The Clock is Ticking
For divorce agreements executed in 2019, payments between former spouses will be treated in much the same way as shared income during their marriage. This means that alimony/maintenance and unallocated support payments will no longer be tax-deductible by the payor nor taxable to the recipient – akin to how child support has always been. Without the tax deduction as an incentive, 2019 alimony payments will likely drop so the payor is out-of-pocket for the same amount as they would have been under the old rules. Even accounting for the recipient’s tax savings, this means they will almost certainly be receiving less than they would have in 2018. It’s a lose-lose proposition for both payor and recipient.
Aside from scrapping deductible alimony, other changes to keep in mind include:
- The Personal Exemption. It was reduced to $0 for all taxpayers this year but may return as a $4,000 exemption in 2026 unless laws change again.
- State and Local Taxes. Deductions for state income and property taxes above $10,000 combined are gone. However, this results in fewer taxpayers being subject to the AMT.
- Moving Expenses. Unless one of the divorcing spouses is a member of the Armed Forces, expenses incurred separating one marital household into two are no longer deductible.
- Legal and Professional Service Fees.Tax preparation, investment advisory fees, and your legal fees incurred for tax planning and to obtain taxable alimony are also gone. Some other changes – such as the raising of estate values subject to inheritance taxes – may indirectly impact high-net-worth divorce negotiations as the need for advance estate planning vehicles such as Life Insurance Trusts and Grantor Retained Annuity Trusts (GRATs) are reduced.
The New Tax Law = New Opportunities for Your Clients
The changes to alimony and unallocated support means supported spouses will likely report far lower taxable income, potentially making them eligible for additional credits previously out of reach.
It’s not unreasonable to assume that a woman receiving $17,000 per month in alimony and unallocated support will now qualify for the Child Tax Credit, recently doubled from $1,000 to $2,000 for children under the age of 17. The adjusted gross income threshold for this credit has now increased to $200,000 for a single filer and phases out at $240,000. To qualify, the parent must have the dependency exemption. While the exemption amount is $0 through 2025, it still is important to negotiate who is entitled to it.
In addition, there are credits available to the “custodial parent” as defined by the IRS, including the credit for child and dependent care expenses, education credits, and the Earned Income Credit.
Keeping the Marital Home Becomes More Expensive
The combination of new limits will make keeping the marital home a more expensive consideration. Because alimony and unallocated support payments will no longer be considered taxable income, it’s too soon to know how mortgage companies will adapt their qualification process. And, when it comes to the mortgage interest deduction, it is now available for interest paid on up to $750,000 of debt on first and second homes combined. However, taxpayers with existing mortgages on first and second homes for up to a total debt of $1 million are grandfathered for interest deductions at that higher level. Add to that the inability to deduct interest paid on home equity loans and there is a lot to consider.
A New Trend for Lump-Sum Property Settlements?
With the elimination of deductions for alimony and unallocated support, it’s very possible we will see more lump-sum property settlements in high-net-worth cases. The appeal of splitting the marital assets and walking away clean can be attractive to both sides. With no tax incentives to provide spousal support income, the interest in exploring lump-sum property settlements can only increase.
Time Is of the Essence
With such major changes taking place, and confusion surrounding new rules, our roles as divorce advisers will be more important than ever for the next few years. As you can see, much of the ability to tailor divorce agreements to suit a couple’s particular financial situation will disappear when we ring in 2019 and the new tax law takes effect.
Heather L. Locus, CPA, CFP®, CDFA® is an owner and wealth manager at Balasa Dinverno Foltz LLC in Chicago where she also heads up the firm’s divorce practice group. She is the author of The Next Chapter: A Practical Roadmap for Navigating Through, and Beyond, Divorce (BDF, 2018). www.bdfllc.com