So, you’ve heard of alimony recapture where there is excess front-loading of alimony payments, but you're not sure what that means or when that applies. No need to sweat. In this article, we'll get you up to speed with alimony recapture as quickly as possible. Let's get started.
Federal Tax Treatment of Alimony Payments and Property Distributions
When spouses divorce, many issues must be decided by a court and included in a divorce decree. Those issues include, but are not limited to, the payment of alimony and distribution of martial property.
Tax Treatment of Alimony Payments
Generally speaking, alimony payments made pursuant to a divorce decree are deductible by the alimony payor under section 215 of the Internal Revenue Code ("Code") and taxable to the alimony recipient under section 71 of the Code. This means that the alimony payor will be able to subtract the amount of alimony paid from their gross income when they file their federal tax return, and the alimony recipient must add the amount of alimony received to their gross income when they file their federal income tax return. This makes perfect sense as alimony is essentially a redistribution of income between former spouses.
Tax Treatment of Property Division
On the other hand, the distribution of property between spouses pursuant to a divorce decree receives no such tax treatment. No deductions or additions to gross income may be made by the divorced spouses, based on property division, when they file their federal income tax returns. Again, this makes perfect sense as the spouses have merely divided what they already owned.
The Federal Government's Cause For Concern
The shifting of taxable income from the alimony payor to the alimony payee can have a substantial effect on the total combined taxes paid by the spouses. Knowing this, divorcing spouses, and their lawyers, can disguise property distributions as alimony awards to gain favorable tax treatment and increase the spouses' overall bottom line.
For example, in lieu of equally dividing a large bank account between divorcing spouses, the higher income earning spouse can retain the entire bank account and pay the other spouse "alimony" equal to one-half the value of the bank account. After all the alimony is paid the spouses will be in the same position as they would have been if each spouse received one-half the value of the bank account.
However, in this example, the higher income earning spouse will be able to subtract the amount of "alimony" paid from their gross income on their federal tax return, and the other spouse will add the amount of "alimony" received to their gross income on their federal income tax return. This shifting of income will presumably lower the total combined taxes paid by the spouses and result in a higher after tax combined net income. The net gain can then be split between the spouses.
The Federal Alimony Recapture Rules
As you might guess, the Internal Revenue Service does not look favorably on the recharacterization of a property distribution to an alimony award in order to achieve favorable tax treatment. To discourage this practice, Congress has enacted what are commonly known that the alimony recapture rules.
The alimony recapture rules are found in section 71 of the Code and call for the recalculation of the spouses' gross incomes where there is excess "front-loading" of alimony payments. The alimony recapture rules apply when alimony payments decrease excessively during the first three calendar years following the first alimony payment made pursuant to a decree of divorce or separate maintenance or a separation agreement.
The alimony recapture rules apply to the first three calendar years of alimony payments. For example, assume the spouses were divorced on December 30, 2010, the first alimony payment was made on December 31, 2010, and the second alimony payment was made on January 1, 2011. In this example, the year 2010 will be treated as the 1st calendar year, the year 2011 will be treated as the 2nd calendar year, and the year 2012 will be treated as the 3rd calendar year.
To determine if alimony payments have been excessively front-loaded, the alimony payments made during the 3rd year are compared against the alimony payments made in the 1st and 2nd years individually. If the alimony payments made in the 1st or 2nd year are found to be excessive, then the excess is recaptured. The recapture amount represents the part of the alimony payments that should have been originally classified as a property distribution.
If alimony payments made in the 1st or 2nd years are subject to income recapture, the alimony payor must add the total recapture amount for the 1st and 2nd years combined to their gross income when they file their federal income taxes for the 3rd calendar year. The alimony recipient has the option to deduct the total recapture amount from their gross income when they file their federal income taxes for the 3rd calendar year.
This article has served merely as a primer on alimony recapture and there is still much to learn and know on the topic. A great next step is to learn how to calculate alimony recapture amounts by reading: Calculating Alimony Recapture Using the Recapture Formula. Reading that article will give you an understanding of the alimony recapture formula and allow you to enter into a divorce settlement agreement without fear of getting caught by the dreaded alimony recapture rules.