GOP tax plan creates surprise divorce penalty

Apparently, nobody saw this one coming. The recently unveiled Republican tax plan would eliminate the current deduction for alimony, potentially changing the calculus of future divorce settlements.

Currently, ex-spouses who pay alimony or similar spousal maintenance agreements can deduct the expense from their federal income taxes and ex-spouses who receive the payments must claim it as taxable income.

Under the GOP tax plan, alimony would no longer be deductible by the payor and alimony income would be tax-free to the recipient. The proposed changes would affect written separation agreements and divorce decrees executed after December 31, 2017, but would not affect existing divorces.

DIFFICULT NEGOTIATIONS

As the person who pays the alimony is likely to be in a higher tax-bracket, the deductibility of payments to a former spouse makes paying alimony more palatable. Take away that deduction and future divorce negotiations could be very difficult, warned Malcom Taub, a high-profile divorce attorney with decades of experience.

For example, assume the ex-husband is a high earner with a combined federal and state tax rate of 50%. If the husband pays alimony of $10,000 per month, he gets a deduction that reduces his net after-tax cost to $5,000 per month, Mr. Taub explained.

Because of the tax break, many divorce attorneys suggest that some of the payments that would normally go to child support be shifted into the alimony category.

Now assume the wife is in the 30% bracket. When she receives $10,000 per month in alimony, her after-tax income is really $7,000. In effect, the wife is receiving an extra $2,000 per month above her ex-husband’s net expenses thanks to the government’s partnership in the transaction.

Under the GOP tax plan, if the high-earning ex-spouse pays $10,000 in alimony, the recipient would receive $10,000 tax free. But the only reason the first spouse would agree to pay $10,000 is that, after tax deductions, it would only cost him $5,000. Without the tax break, he would be reluctant to agree to pay $10,000 in the first place.

“If you eliminate the deduction, the payor will still want to pay the net number of $5,000, but the payee would only receive $5,000, not a net $7,000 as under current law,” Mr. Taub explained. “By eliminating the alimony deduction, you are going to be hurting the payee spouse.”

MORTGAGE INTEREST

The alimony provision is not the only provision in the GOP tax plan that could affect divorcing couples.

Slashing the amount of mortgage interest that would be deductible and capping the property tax deduction at $10,000 could create downward pressure on home prices, negatively impacting ex-spouses who receive the family home as part of their division of assets, said Cheryl Glazer, president of the Association of Divorce Financial Planners and a sole practitioner with a master’s degree in taxation.

In addition, the provision describing the home mortgage interest deduct in the GOP tax proposal only mentions primary residences, not second homes or vacation properties. “A limitation on the allowable mortgage amount is bound to dampen home demand and appreciation in resorts and sought-after urban centers,” she said.

Reverse mortgages, which have become a way for late-in-life divorcing couples to split their home equity, could also be affected.

In 2017, the reverse mortgage lending limit is $636,150—27% more than the $500,000 proposed limit or eligible mortgage indebtedness in the GOP tax proposal. “That means less cash is available to a couple or a solo owner,” Ms. Glazer said. “The gray divorce set will be closed out of transactions that would help them resettle.”

Ms. Glazer urged financial advisers to be aware of the potential coming changes to alimony rules. Mr. Taub, who is the co-chair of the Divorce and Family Law group for the firm of Davidoff Hutcher & Citron in New York, said he is contacting all of his clients who are in the process of separation and divorce negotiations to warn them about the potential December 31, 2017, deadline.