When a couple decides to divorce, each person may harbor fears about how the children will be affected, or how the property will be split. Depending on the exact circumstances, there may be quibbling (or a contentious battle) over issues like alimony, child support or the effect on the family business. What most couples do not readily consider is the effect a divorce may have on their taxes.
Perhaps they should. A recent article in Forbes regarding the new tax Bill in the House of Representatives looks at six tax breaks that most couples stand to lose. In the number one spot is the alimony deduction – and it is not the only reason that the cost of your divorce will increase, both before and after the process is complete. We want to address the cost of your divorce under the new tax Bill, so you can be prepared for what is to come, if it passes.
Tax reform and alimony
Alimony is an adjustment to the income of both the person who pays (the payor) and the person who receives the award. In many cases, there is a significant difference in the earnings between the two parties. This is especially true in a marriage where one person runs the home, and the other earns a salary. When a couple in this position divorces, the two spouses are placed in different tax brackets.
For example: let us say the husband is the person who left the home to work, and he pays 35% of his income in taxes. The husband is ordered to pay $50,000 per year in alimony. The wife only has alimony for her income; as such, she is taxed at a rate of 15%. Under the current tax laws, as Forbes puts it, “alimony payments are deductible by the payor, and considered taxable income to the payee.”
Therefore, the husband would receive a tax deduction so that he would be paying taxes only on the amount less his tax rate as a percentage of income. Husband would receive a tax deduction on the $50,000 in alimony he is to pay to wife, but he won’t receive a 100% deduction on this amount. After the deduction, husband would actually be paying $32,500 to wife, not the full $50,000. The wife will pay taxes on the full $50,000 she receives in alimony, but at her rate of 15%, which only amounts to about $7,500.
Under the new tax plan, this deduction is eliminated. That will have two effects: first, the payor spouse will not receive any tax deduction for any alimony payments made, which will amount to a straight loss to the payor spouse. Second, it will make it far more difficult to negotiate alimony on behalf of the wife who did not work outside of the home, and does not have a skills set that would allow her to seek gainful employment, as there would now be no tax benefit to husband for providing alimony to wife.
Additional tax concerns for continuing education
In Maryland, there is a type of spousal support called transitional alimony. It starts after the divorce decree is final, and continues for a certain length of time, to allow a spouse to learn a new trade, or to go back to school – in short, to allow him or her to become self-sufficient. Under the current tax laws, the interest on student loans is tax deductible, and employers can contribute up to $5,000 to an employee’s education without that $5,000 being listed as income. Many companies, for example, will pay for college classes that are applicable to your work, or offer some form of tuition reimbursement.
Under the new plan, the student loan deduction disappears entirely, and any educational contributions made by your employer will be listed as income. If we use our example from above, the wife will face an additional $750 in taxes (for the contributions to her education by her employer). If she takes out a loan to pay for school, and pays $1,000 in interest on that loan, she will be taxed on that $1,000 ($150, with her 15% tax bracket).
The new tax Bill will cost you more in childcare, too
When figuring the “needs” of a family, an employer can provide child care reimbursement for up to $5,000 each year. When we are preparing budgets for our clients, this is a serious consideration. Under the current tax laws, that $5,000 is not taxable income. However, under the new tax plan, it would will be. Our wife will pay another $750 in taxes (given her 15% tax bracket).
To recap: under the current laws, our newly divorced wife will pay $7,500 in taxes on her $50,000 annual alimony. Under the President’s new tax plan – the tax plan currently being debated in the House – she will instead pay $9,150. However, as she will actually be taxed on $60,000 of income (for continuing education and child care), the chances are good that she might move into the next tax bracket altogether, which, of course, will increase her taxes even more, despite no increase in the actual alimony payments being made to her.
Adding insult to injury with the Capital Gains Tax
Alimony is not the only aspect that could be affected in a divorce. A capital gain is defined as the “increase in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. A capital gain may be short-term (one year or less) or long-term (more than one year) and must be claimed on income taxes.” A capital gains tax is levied on the difference between the original purchase price and the sale price. Generally speaking, the people in the lowest tax brackets tend not to have capital assets that would generate capital gains taxes.
Capital gains taxes can affect what you pay when you sell your home, or when (as in many cases of divorce) one spouse moves out of the family home, and the other spouse retains possession of it. The existing law – which was changed awhile back to make it more fair to the person in possession of the home – is that if you have owned your home, and used it as your principal residence for two of the prior five years, you get an exemption for capital gains on the sale of the house for up to $500,000 for a couple, or $250,000 for a single person.
Under the new bill, you would need to live in the family home for at least five out of the last eight years. Therefore, if you and your spouse bought a home six years ago, there is no exemption. If your spouse lives in the home for more than three years, and you are the one who moved out, you lose the exemption. If you wanted to delay the sale of your home, you lose the exemption.
And the person who moves out? He or she may pay up to $40,000 in taxes.
This new tax bill can and will have long-lasting, and potentially painful, effects on people who are seeking a divorce. It will make negotiations more challenging, and both you and your spouse stand to lose much more than you will gain, if this tax Bill becomes a law. At Cynthia H. Clark & Associates, LLC, we do whatever is in our power to help out clients throughout Maryland retain their assets, minimize their tax burden, and protect their families and futures. To speak with an experienced divorce lawyer at our office in Annapolis, please contact the firm or call 410-990-0090.