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Until the IRS do us part? Marriage and Divorce under the new Tax Bill

February 28, 2018

By Andrew Li, CPA

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Can you put a price tag on love? It appears that the IRS’s answer is “Yes!” According to provisions of the new tax law, many married couples could potentially face hundreds or even thousands of dollars in additional taxes–just from tying the knot! While many analysts have pointed out that the new tax bill has significantly evened out the brackets when going from single to married filing joint (MFJ), other changes have created additional wrinkles in the financial considerations of marriage. Fortunately, savvy financial advisors understand that complexity often results in inefficiency, an in turn, opportunity. This article will explore some broad tax considerations related to marriage or divorce under the new tax law.

In many cases, the married filing joint status is considered advantageous to the single status. However, there are some cases were two individuals would hypothetically pay more filing joint than if they filed two single returns. In those situations, the additional tax from filing joint is known colloquially as the “marriage penalty.” Under the old regime, the tax brackets themselves made the penalty easy to identify:

Tax rate

Single filers

Married filing jointly or qualifying widow/widower

10%

Up to $9,275

Up to $18,550

15%

$9,276 to $37,650

$18,551 to $75,300

25%

$37,651 to $91,150

$75,301 to $151,900

28%

$91,151 to $190,150

$151,901 to $231,450

33%

$190,151 to $413,350

$231,451 to $413,350

35%

$413,351 to $415,050

$413,351 to $466,950

39.6%

$415,051 or more

$466,951 or more

 

Per the tax table above, only in the bottom two brackets are the thresholds for MFJ exactly double those of single filers. For example, a taxpayer and spouse, filing jointly, each with $210,000 of taxable income, would be at a 35% marginal rate. If filing as singles, they would each be in the 33% marginal rate. The marriage “penalty” in this example ends up being $8,488. The marriage penalty becomes even more evident in the top two tax brackets, where there is little or no difference between the thresholds.

At first glance, the 2018 tax brackets appear to have mitigated this problem:

Rate

For Unmarried Individuals, Taxable Income Over

For Married Individuals Filing Joint Returns, Taxable Income Over

10%

$0

$0

12%

$9,525

$19,050

22%

$38,700

$77,400

24%

$82,500

$165,000

32%

$157,500

$315,000

35%

$200,000

$400,000

37%

$500,000

$600,000

 

With the exception of the top 37% marginal rate, all of the joint income thresholds are exactly double those of the corresponding single ones. However, while previously the marriage penalty resulted primarily from the inequity of the income thresholds, the new tax law creates inequities in how one arrives at taxable income itself. A good example of this is the capping of state income and property taxes. Under the new law, both single and married filing joint taxpayers are allowed a deduction of up to $10,000 for such taxes. As such, taxpayers filing jointly could immediately lose the benefit of up to $10,000 in itemized deductions. 

A similar concept applies with mortgage interest, which is deductible as long as it is associated with up to $750,000 of mortgage debt. The $750,000 limit applies to both joint and single taxpayers. This means that two unmarried individuals could jointly purchase a home for $1.5 million and deduct his or her half of the interest in full. (This opportunity did exist under the prior regime as well).

A significant change in the new tax law relates to the treatment of alimony payments. Under the old regime, the payer could deduct alimony payments as an above the line deduction to Adjusted Gross Income, and conversely, the recipient would report the alimony as taxable income. For divorce agreements dated after December 31st, 2018, alimony is no longer tax deductible nor includible in income. (Agreements currently in effect or signed before December 31st, 2018 will still be governed by the old rules). From finance and tax standpoints, alimony payments represent an opportunity to equalize income between two taxpayers – or in other words, reduce taxable income for the individual at the higher rate by shifting it to the individual at the lower rate. The loss of this planning technique will play a big role in future divorce settlements and associated financial planning.

Another important change for higher income taxpayers is the increase in the AMT exemptions and phase-outs. The new AMT phase-outs of $500,000 and $1 million for single and joint statuses, respectively, are significantly higher than the previous phase-outs amounts. Furthermore, the top two causes of AMT, state taxes and miscellaneous itemized deductions, have been either significantly capped or eliminated altogether. As a result, according to one study, the number of taxpayers subject to the AMT could drop by as much as 96%.

Under the old tax provisions, the marriage penalty applied sparingly, primarily to couples where both individuals were high income earners. However, we believe that the new tax laws, specifically those regarding itemized deductions could unexpectedly impact a wide range of individuals, especially those with the following key characteristics:

  1. Taxpayers in higher income states, such as California and New York, will be particularly susceptible to the state and local tax cap of $10,000.
  2. Couples living in separate locations or with multiple properties are more likely to lose part of their mortgage interest or real estate deductions. In particular, single taxpayers with high mortgage balances may lose part of their interest deductions due to the same $750,000 mortgage limit for single and joint filers.
  3. The increased standard deduction puts joint taxpayers at a disadvantage: because of the $10,000 SALT cap, it becomes more difficult for joint filers to exceed the $24,000 standard deduction. If total itemized deductions are below the standard deduction amount, then their tax benefit is effectively lost. Therefore, taxpayers with itemized deductions below $24,000 may want see if they can time their deductions to preserve deductibility. 

Finally, the higher standard deduction yields a unique financial planning opportunity for 2018 divorces. Pooling assets under one taxpayer (to accumulate their associated deductions), in return for a higher (deductible) alimony payment to the other could provide tax benefits to both parties. For example, taxpayers who jointly own two homes could write a divorce agreement to give one of them claim to both houses (entitling him or her to both houses’ real estate and mortgage interest deductions), in return for the other taxpayer receiving a higher (taxable) alimony settlement. At the very least, the taxpayers could come out with an extra $12,000 standard deduction and the tax saved from it.

The purpose of this article is to highlight some important financial implications and tax planning opportunities associated with marriage and divorce under the new tax law. Married couples contemplating divorce should especially be cognizant of the closing timeline to secure deductible alimony. Unmarried individuals may also have opportunities to maximize their tax deductions if / when they marry. At the very least, they should be made aware that marriage could have costs that go far beyond just the wedding.

 

Andrew Li is a tax accountant based in Bethesda, MD. He can be reached at 301-654-9000 x340 or ali@citrincooperman.com.