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Payment of Gain from Sale of Marital Home to Ex-Spouse Was Not Deductible as Alimony

(Parker Tax Publishing March 2018)

The Seventh Circuit affirmed a Tax Court decision that a taxpayer's payment to his ex-spouse under a divorce agreement of half of the net gain from the sale of their marital home was not a deductible alimony payment under Code Sec. 71. The court found that the payment was not alimony because the payment obligation did not terminate on the death of the ex-spouse under state law. Hexum v. Comm'r, 2018 PTC 46 (7th Cir. 2018).

Mark Hexum paid his ex-wife Sherri half of the net gain from the sale of their marital home after an Illinois family court ruled that payment was required under their marital dissolution agreement. The agreement contained separate paragraphs governing Mr. Hexum's maintenance payments and his obligation to pay proceeds from the sale of the marital home to Ms. Hexum.

The maintenance provision required Mr. Hexum to pay a percentage of his salary and specified that such payments were taxable income to Ms. Hexum and deductible under Code Sec. 71(a) and Code Sec. 215 by Mr. Hexum. The agreement incorporated a provision of Illinois law stating that, unless otherwise provided, the maintenance obligation terminated on the death of either party.

Another paragraph provided that the marital home was to be sold and the net equity divided equally. Mr. Hexum agreed to pay all expenses on the property until the sale. From the effective date of the divorce to the date of the sale of the house, he made the mortgage payments and paid to replace some carpeting. These payments totaled approximately $26,000. Mr. Hexum thought that he should be reimbursed this amount before dividing the sale proceeds, but the family court directed him to pay Ms. Hexum half the net gain. Neither the divorce agreement nor the court order requiring Mr. Hexum to pay half the net equity specified if the obligation would have terminated with Ms. Hexum's death.

On his 2013 tax return, without consulting a lawyer or accountant, Mr. Hexum told his tax preparer that he paid alimony in a total amount that included the $13,000 payment, which was half of the amount he paid on the property prior to its sale, and claimed an alimony deduction. The IRS determined that the payment was not alimony, disallowed the deduction, and imposed a penalty.

Observation: The deduction for alimony payments was permanently repealed, beginning in 2019, by the Tax Cuts and Jobs Act of 2017 (TCJA). Pre-TCJA rules will generally continue to apply, however, to alimony payments made under divorce agreements entered into before 2019.

Mr. Hexum petitioned the Tax Court for review and the Tax Court held that the payment did not qualify as alimony. Under Code Sec. 71(b)(1)(D), an alimony obligation must end with the death of the payee spouse, and the Tax Court found that Mr. Hexum's obligation would have continued even if Ms. Hexum had passed away before the sale. The Tax Court also held that the penalty was proper because Mr. Hexum did not consult a professional before taking the deduction. Mr. Hexum appealed to the Seventh Circuit.

Mr. Hexum argued that the payment was not alimony because the equity that accrued in the house after the divorce was not marital property. He also argued that the payment qualified as alimony under Code Sec. 71(b) because it met the characteristics of alimony cited on the IRS's website; although he acknowledged that the IRS website included the requirement that alimony obligations cease at the death of the payee.

The Seventh Circuit affirmed the Tax Court's disallowance of the deduction and imposition of a penalty. The court noted that Code Sec. 71(b)(1)(D) had not yet been interpreted in the Seventh Circuit, so the court adopted a three step test applied by other circuits to determine whether an obligation ends with the payee's death. Under the test, the court first looks to whether the divorce order expressly terminates the liability on the death of the payee. If the divorce order is silent, the court asks whether state law unambiguously ends liability at the payee's death. If state law is unclear, the court interprets the divorce order to resolve the issue.

The Seventh Circuit held that the payment was not alimony because Illinois law unambiguously provided that the payment did not terminate on Ms. Hexum's death. First, the court found that neither the divorce order nor the circuit court order addressed the issue. Next, the court reviewed Illinois law. There are three types of alimony payments in Illinois: (1) periodic maintenance, (2) maintenance in gross, and (3) property settlements. Periodic maintenance obligations terminate on the death of the payee, but maintenance in gross and property settlements are fixed payments that survive the payee. Maintenance in gross may be paired with periodic maintenance but a property settlement may not.

The court found that Mr. Hexum's obligation to transfer half the net gain from the sale was an obligation to pay a fixed amount, so it was either maintenance in gross or a property settlement. The obligation could not be a property settlement because a periodic maintenance payment was required, so it had to be maintenance in gross under Illinois law. As such, the obligation survived Ms. Hexum and therefore did not meet the requirement of Code Sec. 71(b)(1)(D).

The court then went on to find that even if Illinois law were ambiguous, the court would nevertheless have concluded that the payment was not alimony under its interpretation of the dissolution agreement. The court reasoned that the agreement defined maintenance as the payments of a percentage of Mr. Hexum's income and that the maintenance payments were deductible by Mr. Hexum. The agreement also specified that the maintenance obligation ended on the occurrence of certain events including the death of Ms. Hexum. The proceeds from the sale of the house were, however, addressed in a separate paragraph that did not reference modifiability or taxes, which suggested to the court that different treatment was intended. According to the court, viewing the agreement as a whole led it to conclude that the payment was not alimony.

The Seventh Circuit also upheld the Tax Court's imposition of an underpayment penalty. It found that the reasonable cause exception did not apply because Mr. Hexum admitted the law was unclear and he did not consult with a professional before telling his tax preparer how much total alimony he paid during the year.

For a discussion of the definition of an alimony payment, see Parker Tax ¶14,220.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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