9.3 Other Income: Alimony, Gambling, Cancellation of Debt & Exclusions
Key Takeaways
- Under the TCJA, post-2018 alimony is non-deductible to the payer and tax-free to the payee, whereas pre-2019 alimony is deductible above-the-line and taxable to the payee only if four statutory tests are met (cash, written decree, separate households, and termination at death).
- Child support is strictly non-deductible to the payer and non-taxable to the recipient; if a payment is reduced upon a child-related contingency, the reduction amount is deemed child support, and partial payments must be allocated to child support arrears before any amount is treated as alimony.
- Gambling winnings must be reported in full on Schedule 1, Line 8b without netting against losses; gambling losses are deductible only on Schedule A, Line 16 up to the amount of winnings reported, meaning taxpayers taking the standard deduction receive zero tax benefit from losses.
- Cancellation of Debt (COD) income is taxable ordinary income under IRC §61(a)(12) unless a statutory exclusion under IRC §108 applies (such as Title 11 bankruptcy or insolvency immediately prior to discharge), requiring Form 982 and the sequential reduction of tax attributes.
- Compensatory damages for physical personal injury or sickness are 100% tax-free under IRC §104(a)(2), but punitive damages and emotional distress damages arising without physical injury/sickness are fully taxable ordinary income.
Alimony and Separate Maintenance (IRC §71 & §215): The TCJA Watershed Date
Few tax provisions underwent a more radical transformation under the Tax Cuts and Jobs Act (TCJA) of 2017 than the treatment of alimony and separate maintenance payments. For the Special Enrollment Examination, the December 31, 2018 statutory cutoff date is absolute.
1. Divorces Finalized ON OR BEFORE December 31, 2018 (Legacy Rules)
For divorce decrees, legal separation instruments, or written separation agreements executed on or before December 31, 2018:
- Payer Treatment: Deductible as an above-the-line adjustment to income on Schedule 1, Line 19a. The deduction directly reduces gross income to arrive at Adjusted Gross Income (AGI).
- Mandatory SSN Reporting: The payer must enter the recipient's Social Security number on Schedule 1, Line 19b and the date of the original divorce agreement on Line 19c. Under IRC §6723, failure to report the recipient's SSN triggers a statutory $50 penalty and risks complete disallowance of the deduction.
- Payee Treatment: Included as taxable ordinary income on Schedule 1, Line 2a (Alimony received).
2. Divorces Finalized AFTER December 31, 2018 (TCJA Post-2018 Rules)
For divorce or separation instruments executed on or after January 1, 2019:
- Payer Treatment: NOT deductible. Payments are made with after-tax dollars.
- Payee Treatment: NOT taxable gross income. Payments are received 100% tax-free.
- Post-2018 Modifications of Pre-2019 Agreements: An agreement executed on or before December 31, 2018 that is subsequently modified after 2018 retains legacy pre-2019 treatment (deductible by payer, taxable to payee) UNLESS the modification expressly states that the TCJA amendments (repeal of IRC §§ 71 and 215) apply to the modification.
The Four Mandatory Statutory Requirements for Pre-2019 Alimony
To qualify as deductible/taxable alimony under legacy IRC §71(b), a payment must satisfy all four of the following statutory legal criteria:
- Cash Payment Requirement: Payments must be made in cash, check, or money order. Transfers of non-cash property (such as stock, real estate, vehicles), promissory notes, or the provision of services do not qualify as alimony.
- Written Instrument Requirement: Payments must be received under a decree of divorce, decree of separate maintenance, or a written separation agreement. Voluntary payments made without a court decree or formal written agreement never qualify.
- Separate Household Requirement: If the spouses are legally separated under a decree of divorce or separate maintenance, they cannot be members of the same household when the payment is made. Living in separate bedrooms of the same home fails this test (though a temporary 1-month grace period applies if one spouse is preparing to move out immediately).
- Termination at Death Requirement: There must be no legal liability to make payments for any period after the death of the payee spouse, and no liability to make substitute payments (in cash or property) after death. If the agreement requires payments to continue to the payee's estate or surviving children, the entire payment stream is disqualified from alimony treatment from inception!
Child Support Rules, The Child-Contingency Rule & Priority Ordering
Child support receives fundamentally different tax treatment than alimony:
- Universal Child Support Rule: Child support is NEVER deductible by the paying parent and is NEVER taxable to the receiving parent or child, regardless of when the divorce was executed.
The Child-Related Contingency Rule (IRC §71(c)(2))
Divorce agreements sometimes attempt to disguise child support as deductible alimony. Under IRC §71(c)(2), if any portion of a payment specified in a pre-2019 agreement is reduced upon the happening of a contingency relating to a child—such as reaching age 18 or 21, graduating high school, marrying, leaving household, or dying—that portion is treated as child support from day one.
- Example: A pre-2018 decree requires Mark to pay Lisa $3,000 per month, but specifies that payments drop to $1,800 per month when their daughter turns 18. The $1,200 reduction ($3,000 - $1,800) is statutorily classified as child support. Only $1,800 is deductible alimony by Mark and taxable to Lisa.
Priority Ordering for Partial Payments
When a payer is legally obligated under a pre-2019 decree to pay both child support and alimony, and the payer pays less than the total combined amount due during the tax year, the payment is allocated FIRST to satisfy child support obligations in full. Only any remaining excess is treated as alimony.
Numerical Walkthrough: Under a 2017 decree, David is required to pay $1,000 monthly in child support ($12,000/year) and $1,500 monthly in alimony ($18,000/year), for a total annual obligation of $30,000. In 2025, David experiences financial hardship and pays a total of only $15,000.
- Allocation Step 1: Child support has statutory priority. The first $12,000 is allocated to full child support.
- Allocation Step 2: The remaining $3,000 ($15,000 - $12,000) is allocated to alimony.
- Tax Result: David deducts only $3,000 on Schedule 1, Line 19a. His former spouse reports only $3,000 of taxable alimony on Schedule 1, Line 2a. The $12,000 child support is completely ignored for tax purposes.
Comparison Table: Alimony vs. Child Support Across Eras
| Provision | Pre-2019 Divorce Agreements | Post-2018 Divorce Agreements |
|---|---|---|
| Alimony Payer | Deductible Above-the-Line (Schedule 1, Line 19a) | Not Deductible |
| Alimony Payee | Taxable Ordinary Income (Schedule 1, Line 2a) | Not Taxable (100% Tax-Free) |
| Child Support Payer | Not Deductible | Not Deductible |
| Child Support Payee | Not Taxable | Not Taxable |
| Payer Reporting Req. | Payee SSN on Line 19b ($50 penalty if missing) | No reporting on Form 1040 |
Gambling Winnings Reporting & Form W-2G Architecture
Under IRC §61(a), gross income includes all gambling winnings, whether from lotteries, raffles, horse races, casinos, sports betting, poker tournaments, or dog racing.
Form W-2G Issuance Thresholds
Payer institutions must issue Form W-2G (Certain Gambling Winnings) when winnings meet specific statutory criteria:
- $1,200 or more from bingo or slot machines (not reduced by wager).
- $1,500 or more from keno (reduced by wager).
- $5,000 or more from a poker tournament (reduced by wager).
- $600 or more from any other wagering transaction if the winnings are at least 300 times the amount wagered.
- Withholding: A flat 24% regular withholding applies to winnings from sweepstakes, wagering pools, lotteries, and other transactions where proceeds exceed $5,000.
The Absolute Prohibition on Netting
Individual amateur gamblers CANNOT net gambling losses against gambling winnings. Winnings must be reported in full on Form 1040, Schedule 1, Line 8b (Gambling income).
- Example: If a taxpayer wagers $20,000 during the year, winning $15,000 and losing $20,000, they cannot report a "net loss of $5,000" or "$0 income." They must report the entire $15,000 of gross winnings on Schedule 1, Line 8b, increasing their AGI!
Deducting Gambling Losses & The Standard Deduction Trap
- Schedule A Deduction: Under IRC §165(d), gambling losses are deductible only as an itemized deduction on Schedule A, Line 16 (Other Itemized Deductions).
- Capped at Winnings: Gambling losses can be deducted only up to the total gambling winnings reported on Schedule 1. Excess losses are permanently lost—there is no carryforward or carryback of unused gambling losses.
- The Standard Deduction Trap: If a taxpayer claims the standard deduction, they cannot deduct gambling losses at all! The full gross winnings remain in taxable income, while the losses yield zero tax benefit.
- Professional Gamblers (Schedule C): Under IRC §165(d) as amended by TCJA (and made permanent by OBBBA), even for professional gamblers filing Schedule C, ordinary business expenses combined with wagering losses cannot exceed gross wagering winnings.
- 2026 Change to Watch: For tax years beginning after December 31, 2025, OBBBA limits the deduction to 90% of wagering losses (still capped at winnings). For 2025 returns, 100% of losses up to winnings remain deductible. Separately, the Form W-2G reporting threshold for slot and bingo winnings rises from $1,200 to $2,000 for payments made after 2025.
Cancellation of Debt (COD) Income (IRC §61(a)(12) & Form 1099-C)
Under IRC §61(a)(12), gross income includes income from the discharge of indebtedness. When a lender forgives, cancels, or discharges a debt of $600 or more, the lender issues Form 1099-C (Cancellation of Debt) showing the discharged amount in Box 2.
Statutory Exclusions under IRC §108
Discharged debt is taxable ordinary income unless the taxpayer qualifies for a specific statutory exclusion under IRC §108(a), claimed using Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness):
- Title 11 Bankruptcy Exclusion: Debt discharged under the jurisdiction of a federal bankruptcy court in a Title 11 proceeding is 100% excluded from gross income.
- Insolvency Exclusion: Debt discharged when the taxpayer is insolvent is excluded to the extent of the taxpayer's insolvency immediately before the discharge.
- Qualified Principal Residence Indebtedness (QPRI): Discharged acquisition debt on a principal residence, up to $750,000 ($375,000 MFS), for debt discharged before January 1, 2026 (or under a written arrangement entered into before that date). The exclusion reduces the basis of the home, and it does not cover home equity debt used for other purposes.
- Qualified Farm Indebtedness: Discharged debt incurred in farm operations.
- Qualified Real Property Business Indebtedness (QRPBI): Discharged debt connected with commercial real property used in a trade or business.
The Insolvency Calculation Walkthrough (Form 982)
Insolvency is measured immediately before the debt cancellation:
- Assets Included: All assets owned by the taxpayer, including cash, real estate, vehicles, personal property, and even assets exempt from creditors under state law (such as retirement accounts and home equity)!
- Rule of Exclusion: The debt cancellation is tax-free only up to the amount by which liabilities exceed assets. Any canceled debt in excess of insolvency is taxable ordinary income.
Numerical Walkthrough: Credit card company cancels $30,000 of Henry's debt. Immediately prior to the cancellation, Henry had total liabilities of $100,000 and total assets with an aggregate fair market value of $80,000.
- Step 1: Compute Insolvency:
- Step 2: Apportion Canceled Debt ($30,000):
- Excludable Portion: Excluded up to the insolvency amount = $20,000 (reported on Form 982).
- Taxable Portion: Canceled debt exceeding insolvency = $10,000 ($30,000 - $20,000) (reported on Form 1040, Schedule 1, Line 8c as other income).
Mandatory Tax Attribute Reduction Hierarchy
When debt cancellation is excluded under IRC §108, the taxpayer does not escape tax completely free; they must reduce tax attributes on Form 982 in the following statutory order: (1) Net Operating Losses (NOLs), (2) General Business Credits, (3) Minimum Tax Credits, (4) Capital Loss Carryovers, (5) Basis of Property under §1017, (6) Passive Activity Loss/Credit carryovers, and (7) Foreign Tax Credit carryovers.
Other Income Items on the Part 1 Outline
The "other income" topic lists several smaller items that routinely appear as single exam questions:
| Item | Rule | Where It Goes |
|---|---|---|
| Scholarships & fellowships (IRC §117) | A degree candidate excludes amounts used for tuition, required fees, books, supplies, and equipment. Amounts for room, board, and travel, and payments for teaching or research services, are taxable. Non-degree students include the entire grant. | Taxable portion not on a W-2: Schedule 1, Line 8r |
| Barter income | The fair market value of goods or services received in a trade is income, even with no cash. Barter exchanges issue Form 1099-B. | Schedule C if in business; otherwise Schedule 1, Line 8z |
| Hobby income (IRC §183) | Gross income from an activity not engaged in for profit is fully taxable, but hobby expenses are not deductible (the miscellaneous itemized deduction suspension was made permanent by OBBBA). An activity with a profit in 3 of 5 years (2 of 7 for horse breeding and racing) is presumed to be for profit. | Schedule 1, Line 8j |
| Combat zone pay (IRC §112) | Enlisted members and warrant officers exclude all pay for months served in a combat zone; commissioned officers exclude up to the highest enlisted pay plus imminent danger pay. The excluded amount appears in Form W-2, Box 12, Code Q, and the member may elect to count it as earned income for the EITC. | Excluded; not in Box 1 |
| Illegal income | Taxable in the year received (James v. United States); business-type illegal income belongs on Schedule C, with IRC §280E barring most deductions for drug trafficking. | Schedule 1, Line 8z or Schedule C |
| Taxable recoveries | Refunds and reimbursements of amounts deducted in a prior year are taxable only to the extent the earlier deduction produced a tax benefit (IRC §111; see Section 1.1). | Schedule 1, Line 1 (state refunds) or Line 8z |
| Net operating loss deduction | A post-2017 NOL carryforward is entered as a negative amount of other income, limited to 80% of taxable income (see Section 1.1). | Schedule 1, Line 8a |
Constructive Receipt (Treas. Reg. §1.451-2)
A cash-method taxpayer is taxed on income that is credited to their account, set apart, or otherwise made available so that they could draw on it at any time, even if they choose not to. A paycheck available for pickup on December 31, interest credited to a savings account, and payment received by an agent on the taxpayer's behalf are all income when made available. Income is not constructively received when control is subject to substantial limitations, such as a bonus that the employer will not pay until the following year.
Example: A client's check for $4,000 arrives at a consultant's office on December 30, 2025, but she deposits it on January 3, 2026. The $4,000 is 2025 income. Holding the check does not defer it.
Constructive Dividends
When a closely held C corporation pays a shareholder's personal expenses, lets the shareholder use corporate property for personal purposes without paying fair value, makes a below-market or "loan" that is never intended to be repaid, or pays unreasonable compensation to a shareholder's relative, the IRS can recharacterize the benefit as a constructive dividend. It is taxable to the shareholder as a dividend to the extent of the corporation's earnings and profits, and it is not deductible by the corporation. Exam facts usually involve a company credit card used for family vacations or a corporate check written for the shareholder's home mortgage.
Foreclosures, Repossessions & Form 1099-A
When a lender forecloses on or repossesses property, or the borrower abandons it, the lender issues Form 1099-A (Acquisition or Abandonment of Secured Property), showing the loan balance (Box 2) and the property's fair market value (Box 4). If the lender also forgives remaining debt, it issues Form 1099-C, which may replace the 1099-A. A foreclosure is treated as a sale, and the tax result depends on whether the debt was recourse or nonrecourse:
| Debt Type | Amount Realized on the "Sale" | Cancellation of Debt Income |
|---|---|---|
| Nonrecourse (lender can look only to the property) | The entire outstanding debt, even if it exceeds FMV | None |
| Recourse (borrower personally liable) | The lesser of FMV or the debt | Debt forgiven in excess of FMV is COD income (unless an IRC §108 exclusion applies) |
Example: Tom's principal residence (basis $260,000) is foreclosed in 2025 when it is worth $300,000 and he owes $340,000 of recourse acquisition debt, which the lender forgives. His amount realized is $300,000, so he has a $40,000 gain on the home, which the §121 exclusion covers if he meets the ownership and use tests. The remaining $40,000 of forgiven debt is COD income, but it is excludable as QPRI for a 2025 discharge. Had the debt been nonrecourse, his amount realized would have been $340,000 (an $80,000 gain, still excludable under §121) with no COD income. A loss on a foreclosed personal residence is never deductible.
Statutory Exclusions from Gross Income: Gifts, Inheritances & Recoveries
Congress provided specific statutory exclusions for certain wealth transfers and legal recoveries:
1. Gifts and Inheritances (IRC §102)
- Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.
- Post-Transfer Income: Any income subsequently generated by the gifted or inherited property (e.g., rental income or stock dividends) is fully taxable to the recipient.
- Employer Gifts Barred: Under IRC §102(c), gifts from an employer to an employee cannot be excluded as gifts; they are treated as taxable compensation.
2. Life Insurance Proceeds (IRC §101)
- Lump-sum life insurance proceeds paid by reason of the death of the insured are 100% tax-free to the beneficiary.
- Installment Payout Trap: If the beneficiary elects an installment payout over time, the principal death benefit remains tax-free, but any interest portion earned on the unpaid balance is fully taxable as interest income.
- Transfer-for-Value Rule: If a policy is transferred to another party for valuable consideration, the tax exemption is lost (limited to consideration paid plus subsequent premiums), unless transferred to the insured or a partner/partnership of the insured.
3. Legal Damages & Court Settlements (IRC §104(a)(2))
One of the most nuanced areas on the EA exam is classifying legal recoveries:
- Compensatory Damages for Physical Personal Injury or Physical Sickness: 100% Tax-Free. Compensates for damaged bodily integrity.
- Punitive Damages: 100% Taxable Ordinary Income, even if arising from a physical personal injury lawsuit! Punitive damages punish the wrongdoer rather than compensate the victim.
- Emotional Distress / Non-Physical Injury: Damages received for emotional distress, defamation, employment discrimination, or breach of contract are 100% taxable, with one exception: damages paid for actual medical care expenses incurred to treat emotional distress (not previously deducted) are excludable.
Comprehensive Matrix: Taxability of Legal Damages & Settlements
| Nature of Lawsuit / Damage Award | Federal Income Tax Status | Reporting Requirement |
|---|---|---|
| Compensatory for Physical Injury or Sickness | 100% Tax-Exempt (IRC §104(a)(2)) | Not reported on Form 1040 |
| Punitive Damages (Any Case) | 100% Taxable Ordinary Income | Schedule 1, Line 8z |
| Emotional Distress from Physical Injury | 100% Tax-Exempt (Flows from physical) | Not reported on Form 1040 |
| Emotional Distress from Non-Physical Claim | Taxable (Except actual medical costs) | Schedule 1, Line 8z |
| Lost Wages in Discrimination / Slander Case | 100% Taxable Ordinary Income | Form 1040 Line 1 or Schedule 1 |
| Workers' Compensation (Job-related injury) | 100% Tax-Exempt (IRC §104(a)(1)) | Not reported on Form 1040 |
| Qualified Disaster Relief Payments | 100% Tax-Exempt (IRC §139) | Not reported on Form 1040 |
Common Exam Traps on Other Income
- Gambling Netting Trap: Believing that an amateur gambler can deduct losses on Schedule 1. Losses can only be taken on Schedule A as an itemized deduction.
- Pre- vs. Post-2019 Alimony: Applying pre-2019 rules to a 2021 divorce decree. Divorces finalized after 2018 have zero alimony deductions and zero alimony income.
- Child Support Priority: Deducting alimony when child support was underpaid. Payments apply to child support obligations first.
- Punitive Damages Trap: Believing punitive damages in a car accident case are tax-free because the accident caused broken bones. Punitive damages are always 100% taxable.
- Insolvency Calculation Trap: Omitting retirement account assets or home equity when calculating insolvency on Form 982. All assets owned immediately prior to discharge must be counted.
Under a divorce decree finalized in September 2017, a taxpayer is legally obligated to pay his former spouse $1,200 per month in child support and $800 per month in alimony (totaling $24,000 annually). During 2025, the taxpayer pays a total of $16,000. How should the $16,000 payment be treated on the taxpayer's and former spouse's 2025 federal income tax returns?
A financial institution discharges $45,000 of unsecured credit card debt owed by an individual and issues Form 1099-C. Immediately before the discharge, the individual had total liabilities of $120,000 and total assets with an aggregate fair market value of $95,000. The individual was not in bankruptcy. How much of the canceled debt must be included in gross income on Form 1040, and what form must be filed to exclude the remainder?
A taxpayer was injured in a severe industrial machinery accident. In 2025, she settles her personal injury lawsuit against the manufacturer, receiving a total lump-sum settlement of $150,000, allocated by the court as follows: $70,000 for compensatory damages for severe bodily physical injuries, $30,000 for emotional distress directly resulting from the physical injuries, and $50,000 in punitive damages. How much of the $150,000 settlement must be included in the taxpayer's gross income?