Tax Laws & Dividing Assets in Divorce
The following is a transcript of an interview with Heidi Sherman and Jonathan Mishkin. They discuss recent changes to tax laws and how they could impact dividing assets in divorce.
Heidi: Hi, I’m Heidi Sherman with Jill Brittle Family Law Group. This morning I have Jonathan Mishkin with me who manages his own law firm. Jonathan, I wanted to ask you a couple of questions about spousal support in Oregon or alimony. Can you tell us about changes in the tax law that occurred in 2019, I believe related to alimony or spousal support?
Jonathan: Sure! At the end of 2018, President Trump signed into law what you’ve probably heard referred to as the Tax Cuts and Jobs Act. Within that legislation, a significant amount of what we call itemized deductions were removed from the Code. One of those is the alimony deduction. So, if you enter into a divorce or separation instrument, starting in 2019, you no longer get the former tax treatment of a deduction to the payor and income to the payee spouse. It just doesn’t exist anymore. There’s no tax benefit for entering into such so it’s changed the way my understanding is that couples are dividing assets in divorce.
Heidi: …and negotiating spousal support obligations as well?
Heidi: Because we used to write the tax consequences into it and now there aren’t any. So that changes?
Jonathan: Right. Now there’s no benefit or detriment if that’s the right word. So, there’s no leverage any longer really. The only leverage you have is what used to be called the dependency exemption is now just sort of call to credit. But outside of that, you’re correct. I’m seeing a lot of differences in how people separate their assets. Because as you know, you still are protected in any division under Section 1041 of the Internal Revenue Code, which says, in so many words, divorcing spouses can separate their assets tax free. So, there’s still flexibility in your negotiations, you’ve just lost some of the “benefits” that were available in the Code.
Heidi: Well, so let me ask you this. Let’s say that we entered into a divorce agreement, a judgment prior to the change in the Code that included alimony, which would have been deductible to the payor and income to the payee.
Jonathan: Right when originally agreed to…
Heidi: Yeah, so now we’re in 2020. And we’re modifying that. So that we’re either, we’re changing the amount, for example, by changing by modifying that obligation after the Code changed. Are we now creating a different scenario? Does it lose its character as tax deductible and income?
Jonathan: Very good question, I get that asked a lot. The answer’s no. If there was a divorce or separation instrument finalized before the beginning of 2019, I mean, by 12/31 2018, it’s grandfathered, which means these old rules for alimony section 71 of the Code and 215 for the recipient, continue to apply, even if you modify in the future. With the only exception, if you wrote into your modification that you want these new rules to apply. That would be the only way you could undo alimony from a pre TJCA agreement.
Heidi: So, would you recommend that in drafting a supplemental judgment, a modification of that obligation that we include any language about the Tax Code?
Jonathan: I think it’s smart to do so. I mean, there’s plenty of case law that says the IRS doesn’t just have to accept what you write, but it reflects the party’s intent. So, I don’t see why you wouldn’t write something that says ‘it is intended that this modification remain grandfathered and not subject to section, I think it’s 1105, one of the TJCA’. Or if you wanted it to be switched, you would just toggle the word and say this modification now falls within the purview of I always think you should not leave any ambiguity.
Heidi: Very good. Yes.
Jonathan: Because if somebody read it, and you said this clearly applies to pre-law change, there’s really nothing to discuss and the IRS would have to respected if there was an audit of either spouse.
Heidi: Okay. All right. So, sometimes when we’re negotiating an alimony obligation, rather than do what people think is traditional where the payor would pay monthly amounts over a longer period of time, the parties decide they don’t want to do that. They want to disentangle themselves financially. And so, the payor instead is just going to pay one larger lump sum of money to fulfill that obligation entirely. Are there any tax implications to that kind of an arrangement that you see?
Jonathan: There should not be any negative tax implications? I mean, number one, you’re just first modifying your original payment plan. So, I believe it remains grandfather as to tax treatment on the payment. So, if let’s say you were compacting a significant amount of quote, “alimony payments” into one large payment, it should still retain its character is alimony.
Jonathan: So, then going, and you said, you know what happens in a buyout? Well, as most of us are aware, divorcing spouses are viewed as a separating partnership, where nobody’s cashing out, people are just going their separate ways, each with a piece of the collective assets. There’s a section of the Tax Code Section 1041, that says, “transfers incident to divorce are tax-free”, you just essentially take over what we call basis, anything such as that. So, if you were to receive something from your spouse, you literally step into the spouse’s shoes for tax purposes. So, if you sold that asset, you would take over that same gain spread. But there’s no tax for doing it. The consequences I would think about is what’s the built-in taxes to the assets that I’m taking, you know, there’s good assets and there are bad assets. That’s what I’ve been advising clients on when dividing, I go, you know, a house is probably better than retirement because of capital gains versus income tax. Do you see what I mean? And also, like kind exchange rules? I usually have conversations, sometimes about let’s think about down the road, what the consequences and character of the assets are not just what you happen to like or not like.
Heidi: Mm hmm. Good advice. Thank you.