Alimony is the payment of money (i.e., cash) made to, or on behalf of, a former spouse provided that:
a. such payment is made pursuant to a written divorce or separation instrument;
b. the divorce or separation instrument does not designate the payment as one that is not includable in the gross income of the recipient and not allowable as a deduction for the payer;
c. the payer and recipient are not members of the same household at the time the payment is made; and
d. there is no liability to make any such payment after the death of the recipient.
See 26 U.S.C., §71(b).
For income tax purposes, alimony is tax deductible to the payer spouse. Likewise, alimony is includable as taxable income to the alimony recipient.
In a divorce, non-cash property settlements and child support payments cannot be considered alimony and do not qualify for the tax benefit of an alimony deduction. In fact, if a payment, which is otherwise characterized as alimony in a divorce or separation instrument, is (i) reduced or terminated “on the happening of a contingency specified in the instrument relating to a child (such as attaining a specified age, marrying, dying, leaving school, or a similar contingency)”; or (ii) can clearly be associated with such a child-related contingency, then the payment will be treated on the payer spouse’s tax return as non-deductible child support — not alimony — for income tax purposes. See 26 U.S.C., §71(c).
To prevent divorcing spouses from disguising property settlement payments as alimony for income tax purposes, the Internal Revenue Code provides that, in certain stances, a payer spouse must “recapture” the tax benefits of front-loaded alimony payments by adding back to his/her taxable income the amounts of alimony paid to a former spouse in a prior year. Under the “recapture rule,” tax-deductible alimony payments that are made in the first or second year post-separation may be recaptured (i.e., reported by the payer as taxable income) in the third year post-separation when such payments are stepped down by more than $15,000 in the first three years.
Notably, only alimony paid in the first three (3) years post-separation is relevant to the recapture calculation. As such, parties and practitioners should consider alternatives to avoid recapture issues, such as keeping alimony payments equal each year (or even having payments increase each year) leading up to a lump sum payment to terminate the obligation; or structuring a settlement so that any lump sum alimony payment is made in year four or beyond.