Beware: New maintenance law’s tax bite

Colorado divorce cases with maintenance issues are now subject to a new law. This law establishes guidelines for determining the amount and term of maintenance payments based on such factors as the incomes of the spouses and the length of the marriage. While the guidelines are discretionary, the purpose of the law is to provide consistency across Colorado.

What this law does not provide is clear warning of the possible, and perhaps even likely, tax consequences that can devastate the ex-spouse responsible for making maintenance payments. Divorcing spouses must be aware of the Recapture Rule, which may be strictly enforced by the Internal Revenue Service (IRS). The Recapture Rule is designed to discourage spouses from front loading maintenance payments, in order to claim the deduction when the payments are primarily intended to be a settlement of property, which is not tax deductible.

          Unpleasant Surprises for some Spouses deducting Short Term Maintenance

Spouses who think they are paying deductible short term maintenance are going to have unpleasant surprises from the IRS.  They will go along deducting maintenance in years 1, 2 and/or part of 3, then they will have a noticeable and precipitous maintenance decline, after which they could face an IRS audit.  Due to regulations regarding recapture of their maintenance deduction, the maintenance payer will then have to amend all those returns to eliminate the deduction and pay extra taxes. 

The rule applies if the maintenance payments either decrease or end during the first three post-separation years. If the Recapture Rule applies, which is increasingly likely under the new maintenance law, the entire tax benefit gained from claiming a deduction is “recaptured” and paid back to the IRS. Other collateral consequences also exist, such as the other ex-spouse receiving a refund check, the monetary and emotional costs of responding to an audit, and the future increased surveillance by the IRS.

The Recapture Rule is disturbing for those ordered to make short-term maintenance payments, of less than three years. Further, Colorado’s new maintenance law and the accompanying guidelines place the paying ex-spouse in a precarious situation because, while the guidelines are discretionary, courts will undoubtedly be influenced by their very presence and could routinely apply them without thought of the tax consequences. These influential guidelines, regrettably, suggest that in fifty-four circumstances, the payment term be less than three years.

In what circumstances are you subject to the Recapture Rule?

You are subject to the recapture rule in the third year if the maintenance you pay in the third year decreases by more than $15,000 from the second year or the maintenance you pay in the first year exceeds the average of the payments in the second and third post-separation years by more than $15,000. Again, the excess over $15,000 is recaptured.

When you figure a decrease in maintenance you do not need to include the following amounts.

•     Payments made under a temporary support order.
•     Payments required over a period of at least 3 calendar years that vary because they are a fixed part of your income from a business or property, or from compensation for employment or self-employment.
•     Payments that decrease because of the death of either spouse or the remarriage of the spouse receiving the payments before the end of the third year.

How to handle risks of Maintenance Recapture

So how can you limit the chances of being subject to the Recapture Rule? There are several ways, including not claiming the deduction, extending the payment term while lowering the monthly payment, or inflating the third-year payment. Seeking tax advice will almost certainly be helpful. Most importantly, the best way to avoid being trapped by the Recapture Rule is be aware of it.  You should request your tax advisor or attorney to run the calculation before you sign off on your divorce agreement.