Many people struggle with the financial details of their divorce especially if they weren’t the one managing the household finances but the recent tax law changes mean that it’s especially important for you to ask what you need to know about the new tax law changes and your divorce.
If your divorce was already in process last year and negotiations well underway, these changes may mean going back to the negotiation table before you sign your papers. Most people will be reluctant to do that however, some of these changes may have a significant impact on your after-tax income and if you don’t renegotiate now, you’ll lose your opportunity. Once your divorce papers are entered by the court and become court orders, it’s rare that you get a do over and your STBX is likely not going to renegotiate something because the tax law has adversely affected you.
Fortunately, understanding these changes doesn’t mean having to wade through the bill itself. My guest for this Conversation is Michael Wayland who is an assistant professor of business at Methodist University and he recently published a detailed White Paper on the topic. Listen in below (email subscribers click here) or keep reading for a synopsis.
Changes To Alimony
Currently, alimony (also known as maintenance or spousal support) is tax deductible to the payor and taxable to the recipient unless the parties agree otherwise. For agreements signed January 1, 2019 and onwards this is no longer the case and alimony payments become tax neutral. Wayland says this is the most significant issue in the new tax bill because of its impact on “income shifting.”
“If the payor was in the 25 percent tax bracket and spousal support was deductible, for them to pay $100, it really only cost them $75,” explains Wayland. “On the other hand, for the recipient, very frequently they are in a lower tax bracket so they receive the income but they only pay 10 or 15 percent. Let’s say they receive $100, they still get $90 out of the $100.
Through this income shifting the parties would save taxes even though they were no longer married. More than this, it would often enable the payor to pay more to enable the recipient to survive financially post-divorce and to provide more for their children.
Anecdotally, in my work I have found it interesting that couples who are divorcing are often willing to cooperate to ensure that the government gets less of their money.
Under the new law, alimony payments will now be treated in the same way as child support and unlike other elements in the new law, this change does not revert after 2025.
Opinions on how this will impact divorces currently being negotiated vary. I’ve seen some that suggest that there will be a rush to get divorces finalized this year before this change takes effect. This certainly seems true for people who will be paying spousal support but recipients have an opposing interest and may be motivated to delay until after 2018.
Similarly, we could see a rush of people who are already receiving spousal support and who’d like to renegotiate those agreements so their payments become non-taxable and the new law provides for this. It’s too early to know how the courts will handle this. However if your agreement is for non-modifiable alimony then this is likely a non-starter unless both parties voluntarily agree to the revision.
What we also don’t know yet is how states that have formulas for calculating alimony will respond. If those formulas take the after-tax position of parties into account then it’s likely that these formulas will need adjusting.
This change in alimony could possibly also impact child support calculations however it is very dependent on the formulas used by the states and you’re best advised to run the calculations to see if the difference is worth pursuing.
Child Tax Exemptions
Previously, a taxpayer had the ability to claim an exemption for themselves, their spouse, each child and other dependents. Each exemption was worth $4,050.
This meant in divorce negotiations, the parties would make an agreement as to who would claim which child as an exemption. Typically, if there were two children, then each party would claim one child. If there was only one child, then the parties would agree to alternate who would claim the exemption each tax year.
Under the new year, these tax exemptions essentially go away effective as of the 2018 tax year and this will impact existing agreements.
“It really takes some analysis to sit down and say how does this really affect me and my after-tax income,” said Wayland. “That after-tax income is what’s important to be able to support yourself and your children.”
That doesn’t necessarily mean you can ignore these child exemptions. To be able to claim Head of Household filing status (see below), you need to have at least one dependent so you might still make an agreement on child exemption and use this as the basis for who can file as Head of Household.
Another reason is that the child tax credit has increased from $1,000 to $2,000 and this is refundable meaning that the individual receives it even if they don’t owe taxes resulting in a refund. Agreeing who has the child exemptions gives a basis for claiming the child tax benefit. For people earning over $75,000 this is less important because the credit is phased out for incomes higher than this.
Finally, many of these changes are set to revert in the tax year 2026 unless Congress takes action before then. For people whose children are currently in high school, this is likely a non-issue but if your child is in Kindergarten, then these child exemptions could be relevant. Negotiating these now, gives you a fall back position for the future and may avoid having to renegotiate this in the future.
Filing Status Matters
The standard deduction for single filers has been increased as of 2018 from $6,500 to $12,000 maybe to balance out the impact of eliminating the child tax exemption.
“I think the intent of the lawmakers was we’re going to take away these individual exemptions but instead we’re going to raise the standard deduction,” said Wayland.
There are a couple more gems… filing as Head of Household is available to single taxpayers who can claim a dependent (see IRS Publication 501 for the full definition of dependent but broadly it would include a minor child who lived with you for more than half the year). The Head of Household standard deduction has increased from $9,550 to $18,000. Wayland says that filing as Head of Household is more favorable than the single filing status if the filer has income below $51,801. After this, the marginal tax rates for the different filing statuses converge and erase the benefit of the Head of Household filing.
Married Filing Separately No Longer Penalized
Married Filing Separately is another filing status that is used in divorce situations for example where the couple has separated, they have little knowledge or understanding of each other’s finances (or one party isn’t in a position to file their taxes for whatever reason) and still remain married as of the end of the tax year.
Historically, using the Married Filing Separately status has resulted in both parties paying more in taxes and so people would be discouraged by their accountants because of the increased cost. That’s understandable from a financial standpoint but if you don’t know your spouse’s true financial picture, it’s very risky and creates a liability.
Under the new tax bill, that penalty has been eliminated for tax year 2018 and onward and the deduction for Married Filing Separately is now exactly half of married filing jointly, i.e. $12,000.
“I think it will be a positive change,” said Wayland. “Now people will be free to separate their bank accounts, separate their taxes and their income and not worry that the other person is going to do something dastardly tax wise.”
Mortgage Interest Deduction
Often, the decision about who retains the marital home depends on whether they can deduct mortgage interest and this in turn has a significant bearing on that person’s ability to survive financially post-divorce.
Under the new tax law, Wayland said, “because the standard deduction has been raised so significantly, the interest you pay will have to be that much higher to have an impact.” If you are divorced with one child, filing as Head of Household, if you have less than $1,500 per month in mortgage interest and no other itemized deductions, the mortgage interest has no tax benefit.
However, the tax law grandfathered mortgages in existence prior to November 15, 2017 and also allowed for the preferential treatment of these mortgages to be continued if they are refinanced but, and this is a big but, we don’t know the qualifying conditions for refinances. For people getting divorced now that’s particularly relevant since if one party is going to keep the marital home, it usually involves divorcing the mortgage to remove the other party’s name from the mortgage and we don’t know if this would be grandfathered. Nor do we know if a cash-out refinance where the party who is keeping marital home refinances for a higher amount than the existing mortgage to be able to buyout the other party will be grandfathered.
Similarly, interest on home equity loans is no longer deductible through 2025 if the home equity loan is taken after December 15, 2017.
This means that if you are considering refinancing, you need to now ask the mortgage lender how they will treat the new mortgage under these revised rules. Wayland suggests that working with a mortgage broker may give you more options here than working with a single lender.
Michael Wayland is assistant professor of Business at Methodist University in Fayetteville, North Caroline where he teaches classes in Personal Finance, Business Strategy and Business Management. Wayland is also a family and divorce mediator for Christian Divorce Services. You can download a copy of his White Paper here.