Alimony: Deductible and Declarable

I’ve got alimony on my mind. I’m in the middle of a battle with the IRS right now over an alimony issue for one of my clients.

His marital separation agreement dictates that he must pay alimony as well as property taxes and insurance for two homes owned by his former wife. The two homes are alternately used as a principal residence and a rental property by the wife and every year my client makes the payments. And every year he writes them off as alimony on his tax return. The IRS Code and every tax pro will agree that the payments should be allowed as an alimony deduction for him and includable as income for her.

But the auditor is saying no way. We’re at level two in the IRS' Audit Reconsideration Department and I’ve already received one letter that states the deduction is not allowed because the order to make these payments was in the “Division of Property” section of the marital separation agreement rather than in the "Alimony" section.

My response was, “Oh c’mon! Ordering my client to pay these debts on a continuing basis is obviously not a division of property issue. Reload and come back with something better than that.” The IRS went away for about three months and comes back with: We won’t allow it because it "doesn’t look like the payments are for the marital home."

Doesn’t look like? Oh the difficulties with legalese.

So I called and spoke with a revenue agent, explaining that both homes were indeed the marital home for both of them as well as alternately serving as rental properties. “And besides,” I continued, “On page 12 of IRS Publication 504 it states ‘Under your separation agreement, you must pay the real estate taxes, mortgage payments, and insurance premiums on a home owned by your spouse. If they otherwise qualify, you can deduct the payments as alimony on your return.’ All it says is ‘A home,’ it doesn’t indicate principal residence, marital home, teepee, rental property or anything else. It says, ‘A home.’”

The agent responded, “Oh,” with a mixture of surprise and an I-stand-corrected note to her voice. I also reminded her that the IRS allowed these same payments as alimony in its 2007 audit for the same taxpayer. She checked the computer record and responded that yes, it did, but they decided that wasn't the case this year.

My eyebrows shot into my hairline. See how gray tax code is? One day it’s OK, the next it isn’t. That’s what happens when you must legislate for every conceivable situation or deal with every conceivable bureaucrat who takes a very short, straightforward code section and decides to put his or her own spin on it.

The revenue agent told me the person in charge would call me later that day and hung up while I, in mid-sentence, demanded to know exactly who that person is. You see, at that level they won’t tell you. All I wanted was his home phone number.

I didn’t hold my breath waiting for the return call and good thing too--I still haven’t heard back from anyone. So I wisely faxed over my response to the IRS' letter and a synopsis of my phone conversation with the revenue agent.

The agents will likely go into their think tank for another month or so to decide once and for all whether they will or will not allow it. I fought like a son of a gun to make them do the right thing for 2007. Will I wear them down for 2008? Only time will tell.

OK, big exhale and here we go with the basics as outlined in the IRS Tax Code Section 215 and 71(b):

1.) The alimony must be court ordered via a divorce or separation instrument. It cannot be based upon a verbal agreement between you and your former spouse.

2.) The payment must be in cash or its equivalent.

3.) The instrument does not designate the payment as not alimony.

4.) The spouses are not the members of the same household. This requirement applies only if the spouses are legally separated under a decree of divorce or separate maintenance.

5.) There must be no liability to continue to make the payment for any period after the death of the payee spouse.

6.) Payments to a third party on behalf of your spouse under the terms of the divorce or separation agreement are considered alimony, if they otherwise qualify.

If you are the payer of alimony, you may deduct the alimony payments on Line 31a of your Form 1040. On Line 31b, enter your former spouse’s Social Security number. If you are the recipient of alimony income, report the amount received on Line 11 of Form 1040. The IRS will match the deduction with the amount the payee spouse declares. Any mismatch will likely result in an audit for either or both parties. Even if you are on horrendous terms with the ex, it would behoove you to make sure you have your stories straight on the tax returns.

Payments not considered alimony include:

1.) Child support, which is not deductible at all. Nor are child support payments received includable in income,

2.) Noncash property settlements,

3.) Payments to keep up property owned by the person paying the alimony,

4.) Use of the payer’s property.

There are special rules that apply to pre-1984 agreements, excess alimony payments, recapture of alimony, etc. If you have questions about your situation, contact your tax pro.

I’ll keep you posted on the resolution of my client’s case. Wish me luck.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know,” available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.