In December 2017, Congress rushed to pass the Tax Cuts and Jobs Act: a 503-page document that drastically alters several of the popular tax credits and deductions around which many divorcing families structure their financial planning. This first major tax reform in decades affects taxes beginning in 2018 and will have a significant impact on divorcing families. Family lawyers are still working on understanding the nuances of the changes and figuring out how to settle cases while some of the uncertainties in the application of the new law are being resolved by the Treasury Department.
Even the most amicable divorce can be expensive; it simply costs more to maintain two households. Through effective use of the tax code, however, family law attorneys, often working alongside accountants, have been able to expand the pot of family assets and income, lessening the financial impact of divorce. Family law attorneys often use the tax code in negotiating divorce settlements; tax deductions and credits are traded and allocated between divorcing spouses, and the various deductions are taken into consideration when making decisions on alimony payments and home equity buyouts. The changes to the tax code remove important planning tools and will require different approaches to helping divorcing parties adjust to their new financial realities.
Alimony Deduction. Prior to the enactment of the Tax Cuts and Jobs Act, alimony could be deductible from the payor’s gross income and included in the income of the recipient. Because the alimony payor is usually in a higher tax bracket than the recipient, the alimony deduction has been a major planning tool for many high-income divorcing couples. For example, the net cost under federal tax laws to a payor in a 39.6 percent bracket of $1,000 per month in deductible alimony would be $604 (because the payor would otherwise have paid $396 in federal income taxes). If the recipient is in a 25 percent bracket, he or she will pay $250 in federal income taxes on the same $1,000 alimony payment. The difference, $146, is net savings to the couple. This example does not take account of state income taxes; the payor’s net cost would actually be somewhat lower and the recipient’s somewhat higher once state taxes are accounted for.
The Tax Cuts and Jobs Act eliminates the alimony deduction beginning on January 1, 2019. The alimony deduction repeal goes into effect for settlements or court adjudications on or after January 1, 2019. Parties who enter into a settlement in 2018 and who divorce in 2018 can still utilize this deduction. (The law is unclear about whether a couple who have an agreement signed in 2018 and divorce in 2019 can get deductible alimony.) There is still time for couples who are currently separated, and who wish to utilize the old law, to lock in the alimony deduction. That window is rapidly closing.
Mortgage Interest Deduction. Through tax year 2017, single and joint taxpayers could deduct from their taxable income home mortgage interest paid on up to $1,000,000 of acquisition debt ($500,000 for taxpayers filing as married, filing separately). Homeowners with preexisting mortgage debt for acquisition of the property may continue to use the interest deduction under the old law on up to $1,000,000 of debt. Acquisition debt is debt secured by the home that was incurred to buy, build, or improve the property.
The new law reduces the ceiling on the amount of acquisition debt for which the owner can deduct interest to $750,000 ($375,000, if married, filing separately). The $750,000 limit applies to any acquisition debt incurred on or after December 15, 2017 for a newly acquired home with a grace period for certain purchase contracts before December 15, 2017, that close before April 1, 2018.
Under the old law, a homeowner could also deduct the interest on up to $100,000 of debt secured by a home that was not used for acquisition. For example, a couple could have refinanced, taken out an additional $100,000, or gotten a home equity line of credit (HELOC) of $100,000, used it to pay off credit cards or to pay college tuition, and deducted the interest on that $100,000 additional debt. The Tax Cuts and Jobs Act suspends this deduction for tax years 2018 through 2025. Divorcing parties under the old law could use a HELOC or refinance to help in restructuring their finances, for example, by paying off high interest credit card debt, legal fees for the divorce, or to fund transitional expenses for a spouse during the divorce process. They may still elect to do that, but the interest on that portion of the debt will not be deductible.
State and Local Income Taxes. Under prior law, taxpayers could take itemized deductions on their federal tax returns of all state and local income taxes paid and all property taxes paid on a personal residence during the tax year. These deductions provided significant relief to taxpayers, particularly in higher-tax states, such as Maryland, D.C., and Virginia. The new tax act limits these deductions to a combined $10,000 ($5,000 for married filing separately). The high home values and high property taxes in the metro area mean many taxpayers will use most of the cap on property taxes and will get little or no deduction for state income taxes.
Personal and Dependency Exemptions. Of significant concern to many families, the new law suspends the personal and dependency exemption so that the deductible amount is zero for the years 2018 through 2025. The exemption amount for 2018 would have been $4,050, indexed for inflation for each taxpayer, spouse, and dependent child. Because the deduction is not eliminated, which parent is entitled to it can matter because it is tied to the right to use the child tax credit. Unless Congress makes further changes, the current amount, indexed for inflation, will be restored in 2026. Couples with young children should take note.
Child Tax Credit. The Tax Cuts and Jobs Act increased the child tax credit for tax years 2018-2025. The child tax credit is generally available to the custodial parent of any child under 17. The credit is doubled from $1,000 to $2,000 per child. The refundable amount of the credit was also increased from $1,000 to $1,400 where the child tax credit exceeds the taxpayer’s tax liability. In addition, the income limit at which the tax credit is phased out was increased from $75,000 to $200,000 for single taxpayers and $110,000 to $400,000 for married taxpayers filing jointly. Thus, more taxpayers will be able to utilize this credit.
With the drastic tax overhaul of 2017 in the rearview mirror, divorcing couples will have fewer tools they can use to create settlements, at least insofar as the toolbox once contained tax-planning opportunities.