Avoiding Taxes on Transfers of Property in a Divorce Case

Christopher Charles Melcher

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Family Law Attorney

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1

Is the transfer between spouses?

If the parties are still married when the transfer takes place, there is no taxable gain on the transfer unless one of the exceptions discussed below apply. IRC 1041(a)(1). The transfer is treated like a gift. The transferee takes the transferor's tax basis in the property. The effect of the rule is to defer the tax consequences until the transferee disposes of the property. Here's an example: If you bought a painting in 1990 for $100,000 cash, your basis in the property would be $100,000. If you sell the property in 2010 for $1,000,000 to a third party, you will have taxable gain of $900,000. You will have to report it as a long-term capital gain on your tax return and pay 25% federal taxes on that gain. However, if you transferred the painting to your wife in a divorce, no taxes would have to be paid on the transfer. Your wife would take the painting and have to pay taxes on any money she receives in excess of $100,000 if she ever sells the painting.

2

Is the transfer between former spouses?

Many times, the parties will dissolve their marital status prior to dividing their property. In other words, they will get divorce before all of their property has been divided. In those cases, no taxable gain will be recognized on the transfer if (1) it occurs within one year of the marriage or (2) the transfer is related to the cessation of the marriage. Treasury Regulation 1.1041-IT(b) states that a transfer is "related to" the cessation of the marriage when the transfer is required under the divorce or separation instrument, and the transfer takes place within six years from the date of the divorce." The presumption may be rebutted "only by showing that the transfer was made to effect the division of property owned by the former spouses" at the time their marriage ceased. (Regs. ? 1.1041--1T, A--7.)

3

Is the spouse a non-resident alien?

When the spouse who receives property incident to divorce is a nonresident alien, taxable gain will be recognized on the transfer. (IRC ?1041, subd. (d).) The spouse making the transferor will be taxed on the gain (the difference between the fair market value of the property transferred and his or her adjusted tax basis in the property). The rationale for treating nonresident aliens differently is that the IRS assumes that it will eventually receive taxes on any gain realized when a spouse who receives property incident to divorce sells the property, since the spouse takes the transferor's basis in the property; however, in the case of a nonresident alien, there may be little chance that the gain is ever reported or that tax will be paid.

4

If income is being transferred, it will be taxed.

Income is ordinarily taxed to the person who earns it; one vested with the right to receive income cannot escape taxes by an assignment of the right to receive that income to another. Under the assignment of income doctrine, the transferor remains obligated to pay taxes on the accrued income he or she has assigned. The assignment of income doctrine applies when the right to receive the income has already accrued, and the parties assign that right to the spouse who did not earn the income. For example, in a transfer of Series E or EE United States Savings Bonds to a spouse or former spouse, the transferor must include the accrued interest on the bonds in his or her gross income in the year of the transfer. (Rev. Rul. 87-112.) IRC ? 1041 cannot be used to avoid recognition of the gain by transferring the right to receive the income already earned.

5

Is the transfer to a domestic partner?

IRC 1041 only applies to transfers between spouses or former spouses. It does not apply to transfers between domestic partners.

6

Consider tax bases when dividing property.

As discussed in step 1, there can be built-in tax gain in assets. There is usually a difference between the amount of cash which you will receive when an asset is sold, than the amount of "gain" which has to be recognized on the sale for tax purposes. For example, if you borrowed all of the equity from your house to pay personal expenses, you would receive nothing on the sale of the residence. However, you would have to report as a capital gain the difference between the amount you sold the house for versus how much you paid for it. Tax basis is also affected by depreciation. For example, if you tool a depreciation deduction against an apartment building you own, it reduces your tax basis -- meaning that you have to pay more taxes when you sell the property. Make sure you consider the tax basis of assets when dividing them. If tax consequences are not considered when dividing assets, the ultimate division is often far from being equal

Additional Resources

IRS Publication 504

Walzer & Melcher LLP

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