Ten months after the Tax Cuts and Jobs Act (TCJA) passed with great fanfare in December 2017, we're still finding out what it really does for us. If you think that you might join the ranks of divorced people this year or in the future, there are provisions of the TCJA that you may want to pay attention to.
Some of these provisions include eliminating exemptions and most deductions, lowering federal tax rates and raising the limit for the Alternative Minimum Tax (AMT).
However, there are two main areas where the TCJA affects divorcing couples specifically: child support and alimony.
Exemptions and Child Support
The TCJA eliminates the value of the personal and dependent exemptions that were so familiar in years past. It also increases standard deductions from their 2017 values of $6,350 for single filers to $12,000 in 2018; from $9,350 in 2017 for Head of Household filers to $18,000 in 2018; and from $12,700 in 2017 for Married Filing Jointly filers to $24,000 in 2018.
As a result, claiming a Head of Household (HOH) status can make a measurable difference for a newly single parent. To claim it, the taxpayer needs to be unmarried, pay for more than 50% of the household expenses and have a dependent who has lived in the household for more than 50% of the time. If there is one child, only one parent can claim to be HOH for this family.
For divorcing couples, the incremental savings for being Head of Household instead of Single mean that this is likely to be a significant point of discussion in divorce negotiations.
The parent who is Head of Household can also claim the expanded $2,000 Child Tax Credit for each qualifying child, including the $1,400 that is refundable (i.e., you need to owe income tax to benefit). Tax credits are much more valuable than exemptions. Whereas exemptions reduce taxable income, tax credits directly reduce the amount of tax itself.
In the past, parents could alternate taking children as exemptions using IRS form 8332. Of course, these exemptions helped reduce taxable income. As a result, exemptions have been an important clause in separation agreements. However, under the new tax law, exemptions no longer result in a reduction in taxable income.
With TCJA, it is not clear that the Child Tax Credit will be tradeable. Effectively, it would require the IRS to publish a regulation that allows trading of the Child Tax Credit between parents and a form that makes it possible. So far, the IRS has not released that regulation. This is sure to frustrate some parents, as they try to arrange their finances for their post-divorce reality. Their best bet is to negotiate as if the Child Tax Credit will not be tradeable, but write in the agreement that it may be traded if allowed by laws and regulations. Parents could then work on dividing the economic benefits of the credit instead.
The Child Tax Credit and the HOH status provide a measurable boost to the after-tax income of the beneficiary. Thus, they will become an essential consideration of any divorce negotiation involving children.
Starting with agreements that will be signed on Jan. 1, 2019, or later, alimony will no longer be deductible from taxable income by the payor or taxable as income to the recipient. The TCJA ends a longstanding practice that allowed divorcing couples to liberate tax money from the federal government to enhance their post-divorce joint income. Because typically the payor of alimony has a higher income and is usually in a higher tax bracket than the recipient, taxpayers were able to arbitrage the two tax rates and enjoy additional cash flow that would not have been available otherwise. For many, deducting alimony from taxable income was a welcome sweetener to the bitterness of having to pay it.
Abolishing the deductibility of alimony ripples through its other provisions: No longer do divorcing couples have to worry about structuring their alimony to make it comply with tax law. From 2019 on alimony will be considered a simple property transfer pursuant to divorce with no income tax consequences.
The change in the law effectively makes alimony more burdensome to payors. With deductibility, alimony reduced a payor's income taxes. Thus, the net impact to the payor's cash flow was the alimony paid minus the taxes saved. Now that deductibility is eliminated, the impact on cash flow is just alimony.
Conversely, recipients will no longer have to pay income taxes on their alimony, theoretically resulting in higher cash flow. However, it is the view of this writer that as a result of this change, alimony awards will trend down to take into consideration the cash flow impact on the payor. In all likelihood, recipients will end up paying the price.
This clawback of tax revenue was projected to raise $8 billion over 10 years, a trifle compared to the $1.5 trillion cost of TCJA.
While this change in alimony treatment comes in 2019, separation agreements concluded in 2018 and before will abide by the old rules unless the divorce agreement specifies otherwise. Speak with your mediator or your lawyer: There may still be time to complete a separation agreement before the end of the year.
A Last Word
Much of the TCJA sunsets in 2025, reverting in 2026 to the rules that were in force until 2017, with one notable exception: alimony, which, under the current law, will continue to be non-deductible in 2026 and later. As a result, separation agreements should take into account that they may be subject to one set of tax rules until 2025, and then may have to revert to another one in 2026.
Can we count on Congress to extend the TCJA beyond 2025, as it did with the Bush tax cuts in 2013? Perhaps. Lawmakers are loath to vote for anything that could appear as a tax increase. However, it would not be prudent to count on Congress' good heart! Thus, separation agreements should maintain sufficient flexibility to take future changes in the tax environment into account.
Overall the TCJA will likely be a net cost to divorcing couples, especially those with child support or alimony obligations. However, knowing the rules can still improve a divorcing situation. Checking with a Divorce Financial Planner is likely to pay dividends.
Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. We make no representation as to the accuracy or completeness of the information presented. To determine a course of action that may be appropriate for you, consult with your attorney, financial planner or tax advisor before implementing any plan. Tax laws and regulations are complex and subject to change, which can materially impact investment results.
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