If your marriage is on the rocks, you should move quickly if you treasure having options. This is the advice many professionals are offering as substantial changes loom with the implementation of the Tax Cut and Jobs Act of 2017 in the United States.
As we start to dig through the new US tax laws, it’s apparent there are big changes on the horizon for divorcing couples, especially those with high net worth. This early in the process many IRS rules are still being made, but some things are already coming into focus.
Most of the changes in the new US tax laws are driven by the movement toward larger standard deductions, fewer itemized deductions, lower tax rates, and reducing personal exemptions to $0, at least until 2025. Before this law, around 70% of taxpayers used the standard deduction.
By doubling the amount of the standard deduction and limiting itemized deductions, it’s projected 95% of taxpayers will fall into this category going forward. Like any other big change, adjustments will be complex in the beginning. For divorcing couples, the biggest change starts January 1, 2019.
Due to New US Tax Laws, Divorce is a Whole New Ballgame in 2019
On New Year’s Day 2019, the whole support landscape shifts. Payments for maintenance/alimony or unallocated support in new agreements will no longer be either deductible or reportable as income on tax returns. These payments will be treated the same as shared income before the household was split in two. This change is permanent. Divorce agreements are meant to last forever, and if yours is executed before the end of 2018, it will govern future tax liabilities for as long as the agreement lasts.
To a large degree, this change is due to the complexity of the process. Since there was no tax reporting of support payments through a Form 1099, divorcing spouses often, and quite innocently, reported different numbers on their tax forms. This became a nightmare for the IRS to track.
However, there is also the matter of lost income to the government. With support payments currently deductible, the amount paid moves from a higher tax bracket paid by the supporting spouse to a lower rate paid by the supported spouse. If the supporting spouse was in the 39.6% tax bracket, and the supported spouse is now in a 20% tax bracket, the government loses almost 20% – at least on agreements completed before the ball drops on 2018. It’s also important to note that any prenuptial or post-nuptial agreements based on previous tax laws may have unintended consequences if a divorce agreement is executed after December 31, 2018.
Some Good News for High-Net-Worth Families
Let’s look on the bright side of the equation. First, many divorcing spouses will no longer be faced with the Alternative Minimum Tax (AMT). Changes, such as limiting the deductibility of state and local taxes (SALT) to $10,000, elimination of deductions for home equity loan interest and the loss of ability to deduct professional fees, means fewer high-net-worth taxpayers will see their taxable income subject to the AMT.
With maintenance/alimony and unallocated support payments no longer regarded as income, some spouses are going to qualify for tax credits never available to them before. Consider the case of a divorcee whose major source of income is the $15,000 in monthly alimony she receives. If her divorce agreement was executed before the end of this year, she will show at least $180,000 of income, too much to qualify for tax credits for education, child care and the like.
But, if the divorce is executed after December 31, 2018, she will show little or no income, making her potentially eligible for any number of tax credits to help defray these costs. Under the new tax law, some of the thresholds to receive these credits increase significantly, making it easier for many people to take advantage. Child tax credits will be among those coming within easier reach for high-net-worth people who didn’t qualify in the past.
Child Tax Credits Increase
The size of this credit doubles in 2018, from $1,000 to $2,000 for children under the age of 17. There is now an additional $500 Child Tax Credit for full-time students who are 17-24. In 2018, the threshold for these tax credits also went up significantly to $200,000 for single filers and $400,000 for married filing jointly. The credit will phase out for those earning $240,000 as single filers and $440,000 married filing jointly.
While the personal exemption was reduced to $0 for tax years 2018 – 2025, to qualify for the Child Tax Credits you must be the parent that can take the dependency exemption so it is still important to negotiate.
There are additional credits for child and dependent care expenses education credits and the Earned Income Credit available to the custodial parent, defined by the IRS as the one with the most overnights during the year. If parents enjoy an equal number of overnights, the one with the highest Adjusted Gross Income is considered “custodial.” The income thresholds for these vary.
The New Math for Real Estate and Retirement Accounts
Deciding whether to keep the house has always been a major concern for divorcing couples. It is one of the most frequent questions divorcing women ask since they fear both the upheaval of moving and the financial ramifications of home ownership.
This is one of those areas that is still coming into focus since 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 along with limitations on deducting real estate taxes and there is a lot to consider
Because the spouse receiving payments will not report them on their taxes as income, this may derail contributions to IRA accounts. For divorces executed before the end of 2018, a non-working ex-spouse can use taxable maintenance/alimony or unallocated support payments to qualify for contributions to IRAs.
What happens if those payments are no longer considered income? It’s quite possible that without this taxable income, you’ll no longer be able to grow your retirement accounts with the maximum allowable yearly contribution of $5,500, or $6,500 if you’re 50 or older. Professionals are keeping a close eye on how the rules are formed so they can advise you in the future.
In the meantime, you can savor the fact that exemptions for estate tax have been raised to $11 million and tax rates have been lowered through 2025. This is the amount you can pass to anyone during your life or at death without any tax due and may mean there will be less need to create Life Insurance Trusts and other estate planning tools that are complex and expensive.
What You Might Expect After 2018
Even with a few things still up in the air, it’s apparent many divorcing couples will be facing a whole new world when the sun rises on 2019. For example, it’s quite possible we’ll see more upfront lump sum property settlements where divorcing spouses agree to divvy up the assets and walk away.
With no deductions for future payments in new agreements after January 1, 2019, the higher earning spouse may be willing to pay the entire settlement at the time of divorce in order to walk away clean and keep all their future income.
The recipient may be willing to accept a little less to have the flexibility to move on with their life without having to wait for a check every month. This is especially true for divorcing individuals who would like to remarry or live with a new partner in the future as support payments typically stop under those circumstances.
This has been an attractive strategy for only a few couples historically. One woman got 86% of a sizable estate because her husband valued the ability to walk away free and clear and keep all his future income, rather than take advantage of tax breaks for monthly maintenance payments.
Without the deductibility benefit, this may become an attractive option for more couples in the future. Of course, when considering this type of settlement, a couple must consider the risk of job loss and other unexpected changes in circumstances in the future.
There’s Still Time to Avoid the New US Tax Laws
If there is no hope for your marriage and you want the flexibility to use your divorce agreement to lower future tax liabilities, there is still time to move. If you get started now and don’t get side-tracked by unnecessary fights, you’ll likely be able to execute a final divorce agreement and enjoy the next New Year’s Eve celebration as a single person. In this case, time really is money.
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 has been named one of America’s Top Women Advisors by Forbes and was named a Top 200 Wealth Advisor Mom by Working Mother. In 2018, she authored The Next Chapter: A Practical Roadmap for Navigating Through, and Beyond Divorce. www.bdfllc.com/people/heather-locus-cpa-cfp-cdfa.