Alimony

For purposes of the federal income tax, alimony refers to the written obligation of one spouse to make periodic cash or cash equivalent payments to the other spouse for maintenance and support during the time the couple is (1) separated, (2) involved in a matrimonial lawsuit, or (3) divorced. Alimony is also correctly described as maintenance, support, maintenance and support, or spousal support.

In determining the alimony deduction, checks and money orders are considered to be cash equivalents. However, attempts to satisfy an alimonial obligation by (1) transferring property or services, (2) making provision for the free use of property, or (3) executing a debt instrument are not considered alimony under federal tax law and therefore not deductible.

is deductible by the payor spouse and taxable income to the recipient spouse. In the lexicon of tax law, alimony is a deduction from gross income or what is otherwise known as an above the line deduction; in short, a taxpayer doesn’t have to itemize in order to write off alimony payments.

Alimony may be treated as child support if payments change in response to the happening of an event or contingency relating to a child. Specifically, payments designated as alimony may be reclassified as nondeductible child support if they are reduced (1) within six months before or after a child reaches age 18, 21, or the local age of majority; (2) on two or more occasions within a year after a child reaches a certain age between 18 and 24; or (3) at the time a child marries or dies. And if the payor spouse is obligated to make both child support and alimony payments but comes up short, proceeds received by the recipient spouse are first applied to child support. In other words, alimony is deductible only after child support has been paid in full. For a lucid summary of alimony versus child support click on (pdf file).

In deciding whether a payment qualifies as deductible alimony, the Internal Revenue Code trumps state and domestic relations laws, including divorce agreements and court orders. What may be considered as alimony under state law may not be considered as such under the Code and vice versa.

To be deductible, alimony must be governed by a written divorce or separation instrument. Divorce or separation instruments include “(A) a decree of divorce or separate maintenance or a written instrument incident to such a decree, (B) a written separation agreement, or (C) a decree…requiring a spouse to make payments for the support or maintenance of the other spouse” [Code Section 71(b)(2)]. The instrument does not have to be binding under state law but it must clearly outline the terms of support for the separated parties. Payments made before the execution of such instrument or prior to the effective date of a decree or order of support are not deductible as alimony even if the divorce or separation instrument is made to retroactively account for these payments. And voluntary payments or payments that exceed what a written divorce or separation instrument requires are not alimony and hence not deductible.

Payments qualify as alimony under the Code only if all the requirements listed below are satisfied:

  1. Payments must be made in cash or cash equivalents;
  2. Payments must be made to, or on behalf of, a spouse or former spouse;
  3. The divorce or separation instrument cannot explicitly state the payments are not alimony;
  4. Payments are not characterized in the divorce or separation instrument as being nondeductible by the payor spouse and tax-free to the recipient spouse;
  5. Payments cannot be designated as, or considered to be, child support;
  6. Payor and recipient spouses cannot be members of the same household at time of payment;
  7. Payor and recipient spouses cannot file a joint income tax return; and
  8. The obligation to make payments must end at the time of the recipient spouse’s death.

Although listed as constraints, items (3), (4), and (5) above also create financial planning options for the divorcing or separating couple, even if the primary purpose of any given allocation of alimony and child support payments is to avoid tax. But the recipient spouse should be aware that alimony ends upon the death of the payor spouse.

The reason for requiring alimony payments to be made in cash or cash equivalents is to ensure that noncash property transfers between spouses incident to divorce conform to Section 1041 of the Code. In effect, for Section 1041 property transfers incident to divorce (i.e., transfers made within one year of the divorce or related to the dissolution of the marriage), the transferee spouse takes a carryover basis, that is, a basis and holding period equal to that of the transferor spouse. Section 1041 transfers are not deductible by the transferor spouse and not income to the transferee spouse.

Cash payments to third parties by the payor spouse to satisfy a spouse’s or former spouse’s obligations (e.g., automobile insurance, credit card bills, rent, tuition, etc.) qualify as alimony. But if a spouse or former spouse resides in a house owned by the payor spouse (that is, payor spouse is the principal obligor on the mortgage debt), payments on behalf of the spouse or former spouse are not considered alimony. A similar restriction is placed on life insurance: the recipient spouse must be the irrevocable beneficiary and owner of the policy for payments to qualify as alimony.

The IRS considers the substance of a live-in divorce or separation to be tax avoidance despite the existence of a formal, written instrument. In other words, because of the income-shifting potential of a live-in divorce or separation and the negative effects on federal revenue intake that could result from such arrangements, payor and recipient spouses cannot live together.

An essential element in the legal definition of alimony is the existence of a living person for a payor spouse to maintain or support. Therefore, payments made after the death of a spouse or ex-spouse cannot, by definition, be designated as alimony.

Payments must be periodic in nature, and the consider uneven cash or cash equivalent payments posing as alimony to be in substance nondeductible lump sum property settlements unless the lump sum payment represents past-due alimony. If alimony payments decrease significantly after the first or second year of scheduled payments, where a decrease of more than $15,000 is considered significant, the payor spouse may be subject to Section 71(f) recapture.

The first component of possible recapture is based on a comparison between alimony payments in the second and third years. If the second year payment is more than $15,000 higher than the third, the excess is subject to recapture. The second component of recapture examines the difference between the first year payment and the average of the second and third year payments. Again, if the first year payment is more than $15,000 higher than the average of the second and third year payments, then the excess must be recaptured.

For example, if alimony payments are $40,000 in the first and second years and $20,000 in the third, the payor spouse will have to recapture a total of $5,000 in the third year. In this calculation, the first comparison between the second and third years shows a difference of $20,000 ($40,000 second year payment minus $20,000 third year payment), with $5,000 being subject to recapture ($20,000 difference minus $15,000, the amount earmarked in the Code as representing a significant difference between alimony payments). The second comparison between the first year payment of $40,000 and the average of the second and third year payments ([$40,000 + $20,000]/2 or $30,000) yields a difference that is less than $15,000 and therefore not subject to recapture. Click on for a quick and dirty application for those with math anxiety.

However, alimony payments made after the third year are not subject to the recapture provisions of Section 71(f). Furthermore, Section 71(f) recapture does not apply to significant decreases in alimony payments brought about by (1) recipient spouse’s remarriage or death or (2) changes in payments lasting for at least three years and fixed as a percentage of income from the payor spouse’s business, employment, or property.

In the case of recapture, excess alimony deductions taken by the payor spouse are reversed in year three of the payment schedule by including these amounts in income. A similar process holds for the recipient spouse: amounts previously booked to income are reversed by means of a deduction reported on the third-year tax return.

Alimony trusts are governed by Section 682(a) of the Code and, in terms of deduction and inclusion, produce results similar to those under regular alimony arrangements: trust income from a properly crafted alimony trust is excluded from payor’s gross income but is taxable to the recipient spouse.

Additional relevant articles on the federal income tax consequences of alimony are listed below:

Many happy returns, Roger

Home Office Deduction

Generally speaking, deductions are not allowed for the business use of a personal residence, but Section 280A of the Internal Revenue Code permits a deduction for costs allocable to the portion of a home used as (1) the principal location of a trade or business or (2) the primary fixed location where administrative and management functions associated with a trade or business are performed. Expenses for the business use of a taxpayer’s home are listed on IRS Form 8829 (visit my Tax Forms page on the navigation menu above to see a copy of Form 8829 and instructions for this form under the “2007 Tax Forms” heading). Although managing an investment portfolio is an income-producing activity, it is not considered by the courts to be a business activity. (Translation: The cost of using a home office to manage an investment portfolio will not be included on any list of allowable unless the individual claiming the deduction is a professional trader or dealer in securities.)

Unfortunately, the home office cannot double as a nursery or recreation room. To qualify for the deduction, the portion of the dwelling unit or separate structure designated as the home office must be used exclusively and regularly for the taxpayer’s trade or business or related administrative and management activities. However, office space in the home doubling either as storage space for inventory and product samples or personal space in the case of a properly licensed daycare facility will not disqualify the home office as a principal place of business. Home office space can be used for more than one business activity and still qualify for a deduction provided all activities satisfy either the business or administrative use tests (see below). But if one of the uses doesn’t meet the convenience of the employer test (i.e., the use is not a direct and required part of the employee’s job), it fails the exclusive use test (an essential element of both the business and administrative use tests) thereby spoiling the deductibility of all other conforming business activities.

Changes to the Internal Revenue Code in 1976 restricted the scope of the home office deduction to a “dwelling unit exclusively used on a regular basis…as the principal place of business for any trade or business of the taxpayer” [Section 280A(c)(1)]. But with the Tax Reconciliation Act of 1997, Congress broadened the phrase “principal place of business” to include “a place of business which is used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer if there is no other fixed location of such trade or business where the taxpayer conducts substantial administrative or management activities of such trade or business.” By virtue of the Tax Reconciliation Act of 1997, a self-employed taxpayer or employee using a home office for administrative and management activities and meeting the convenience of the employer test can do in 1999 and beyond (effective date of changes to Section 280A under the Act is December 31, 1998) what Congress tried to foil in 1976, namely, take a deduction for home office expenses. While occasional or incidental business use of a home office would fail the so-called business use test, a taxpayer regularly using a portion of his or her dwelling unit or separate structure for administrative or management activities, activities arguably incidental and occasional in character (a self-employed plumber, for example, is not in the business of doing things “administrative”), would be eligible for the home office deduction (in other words, taxpayer would pass the administrative use test).

Some generalizations are in order. First, the home office deduction cannot exceed the gross income from the related business activity, where gross income is reduced by home expenses that would be deductible anyway (e.g., , property taxes, etc.) and business expenses not directly connected to the home office (to illustrate, advertising, car and truck expenses, office supplies, salespersons’ expenses, wages and salaries) but deductible elsewhere. The point of subtracting these amounts from gross income is to prevent the taxpayer from deducting expenses twice. Home office expenses are deducted in the following order:

  1. The portion of indirect expenses (costs benefiting the entire household) allocable to the home office (see list of “indirect expenses” below); and
  2. Depreciation attributable to the home office.

Items (1) and (2) above cannot create a loss although they can be carried forward indefinitely.

Second, to pass the business use test, the home office must be used regularly and exclusively in at least one of the following capacities listed below. (Note: Use that is only incidental and occasional will fail the exclusive use test, causing the taxpayer to fail both the business and administrative use tests.)

  1. As the principal place of business;
  2. As a place to meet with clients or customers in the ordinary course of business;
  3. As a place to perform administrative or management duties required by taxpayer’s employer provided taxpayer has no other place to perform such duties, with the proviso that although deductible, employee home office costs are listed by the IRS as one of many miscellaneous itemized subject to a 2% of adjusted gross income (AGI) floor; or
  4. As a separate structure not attached to the dwelling unit that has a credible and proximate relation to the business (for instance, artist’s studio, greenhouse for a floral shop, shed used as bookbinding shop, etc.).

To pass the convenience of the employer test, a home office must be established on the basis of an employer’s need and in response to the fact that the employee has no other place to perform required administrative and management duties.

Third, a home office will pass the administrative use test if it meets two conditions:

  1. The office is used regularly and exclusively for administrative and management functions of the trade or business (common administrative and management functions include billing customers, keeping books and records of the business, making appointments, ordering supplies, and writing sales reports, among others); and
  2. There is no other fixed location where the taxpayer performs these functions.

A taxpayer who performs administrative and management functions at locations other than the home office will not be prevented from taking a deduction under the following circumstances:

Fourth, a home office can be depreciated, but depreciation is limited to the business use percentage of the home (viz., the area used exclusively as a home office divided by the total area of the dwelling unit). Any depreciation taken after May 7, 1997 may be subject to recapture upon sale of home. Put differently, even though a married taxpayer filing jointly can exclude from income up to $500,000 of gain on sale of a principal residence (the exclusion is $250,000 if married filing separately), he or she must recognize gain to the extent of home office depreciation that is, or could be, taken after May 7, 1997; click on for more information. The depreciable basis of a home office is the lesser of the cost or fair market value of the portion of the dwelling unit devoted to business use. The depreciable life (cost recovery period) of a home office is 39 years and starts on the date the office is first used for business. Since land is by definition a non-wasting asset with no determinable useful life, it is not included as part of the home office’s depreciable basis.

Fifth, the portion of indirect expenses related, and allocable, to the dwelling unit’s office space can also be deducted:

Finally, with the exception of capital expenditures (cost outlays that improve or extend the useful life of the property), direct expenses of keeping the home office functional are 100% deductible, including the cost of a separate phone line dedicated to business use.

For those worried about tax expenditures (shorthand for the idea that to maintain a given, and expected, level of public services, a polity must increase federal spending in order to make up for any reduction in revenue intake by reason of tax breaks), the more liberal rules for the home office deduction are a vexation. But for the self-employed or employees eligible for the home office deduction, these rules are the means to considerable tax savings, making it possible to (1) convert the nondeductible personal expenses of maintaining a residence into deductible business expenses, (2) reclassify Schedule A itemized deductions (some of which are subject to a 2% AGI floor) as Schedule C business deductions, and (3) re-christen previously nondeductible personal commuting expenses as deductible business expenses since the taxpayer is now traveling between his or her principal place of business (home office) and another work location in the same trade or business, even if the other work site is temporary and regardless of distance. Click on to see why having an office at home can provide the taxpayer with an auto expense bonus, that is, make commuting expenses deductible.

For more information on the home office deduction, consult the list of relevant articles below:

Many happy returns, Roger

Investment Interest Deduction

The Tax Reform Act of 1986 put a chill on many individual investors by enacting what is informally known as the “investment interest limitation,” in other words, limiting the deduction for interest paid to purchase or hold investments (including interest on margin accounts) to the amount of net investment income from such investments. Investment interest expense (abbreviated in this article as investment interest) is one of the itemized deductions not subject to phase out for high income taxpayers. If investment interest exceeds net investment income, it can be carried forward indefinitely.

Investment interest is defined as interest paid on debt to buy or carry investment property. Investment interest to buy or carry tax-exempt securities (e.g., municipal bonds) or other tax-free investments is not deductible. On the whole, investment interest does not include interest related to passive activities, , or capitalized construction period interest.

Investment property comprises the following:

  1. Property such as stocks, bonds, insurance portfolio products, patents, etc. producing dividends, interest, annuities, and royalties not arising in the ordinary course of a trade or business owning such property;
  2. Property in (1) above but aggregated in a mutual fund or other pooling device and generating gain or loss from holding or selling such property;
  3. Property held for investment in non-passive activities, although an exception has been granted for one type of passive activity, namely, a working interest in an oil or gas property held directly or through an entity not limiting taxpayer’s liability; and
  4. Any interest in a non-passive trade or business activity in which the taxpayer is not a material participant.

Gross income from investment properties includes the following items:

Net investment income is gross income less reasonable investment expenses, other than interest, with a credible and proximate relation to the production or collection of income from investment properties. There is a catch–investment expenses are classified as miscellaneous expenses and therefore deductible only to the extent they total more than 2% of adjusted gross income. Common investment expenses include accounting fees, investment counseling, legal fees, and rent for safe-deposit boxes.

Other relevant articles on the investment interest deduction follow below:

Many happy returns, Roger

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