Taxation of the Transfer of Property Incident to a Separation or Divorce Agreement

Taxpayers going through a separation or a divorce are already going through a very difficult time. One, if not both of the former spouses is likely adjusting to a new and different living arrangements and likely a worsening financial situation. Traditionally, property that was transferred incident to a divorce or separation was considered a taxable transaction. In United States v. Davis, the Supreme Court made the determination that the transfer of property from a husband to a wife in exchange for the wife’s agreement to not pursue a court-ordered division of assets was a taxable transaction. While that case law was in effect, transferors of property incident to a divorce were simply treated as making a taxable disposition of assets, paying tax on the difference between the transferor’s basis and the fair market value of the property being transferred. The Court reasoned that many states at the time (1962) did not give a wife many ownership rights in the marriage. In Davis, the Court believed that Delaware’s (where the case was originally brought) scheme for marital ownership gave a wife only “illusory” rights and thus, the transfer, and other transfers like it, should be taxable because there wasn’t actually a division of property.

Congress recognized that the ruling in Davis may be the correct outcome from a technical standpoint, but that the results lacked compassion for the position that the parties were in. In an effort to show empathy for taxpayers that are going through a very difficult period and to provide uniformity among the taxation of transfers pursuant to a divorce in all 50 states, Congress enacted Section 1041 of the Internal Revenue Code.

The Basic Rule

Under Section 1041(a) of the Internal Revenue Code, spouses can transfer property to each other (or ex-spouses if the transfer is pursuant to a divorce) without recognizing gain (or loss) on the transaction. Thus, this rule covers both separations and divorces. Much like many other non-recognition provisions in the Internal Revenue Code, the transferee spouse who receives the property takes a carryover basis without receiving a step in basis to the Fair Market Value at the time of the transfer. Some policymakers and practitioners argue that this rule disparately impacts the recipient spouse as they will have to recognize any built in taxable gain in a transferred asset upon a subsequent taxable disposition of any property received as a nontaxable property settlement.

Example: Husband and Wife own an antique collector car prior to their divorce. The car has a current fair market value of 100x and a tax basis of 25x (what they paid for the car). Under California community property law, the husband and wife are each considered to own half of the collector car.  Pursuant to a settlement agreement, the husband agrees to transfer his 50% interest in the car to the wife. Although the sale of any portion of the antique collector car would have yielded taxable capital gain under normal circumstances, there is no tax gain or loss recognized with the husband’s transfer of his 50% interest to the wife because Section 1041 applies. The Wife will take the Husband’s half of the car with a carryover basis of 25x. Therefore, at the end of the day, the Wife will continue to hold the antique car in the same manner (from a tax perspective) as the marital partnership did prior to the divorce. If the wife were to sell the car a month after receiving her husband’s 50% community property interest for 100x, she would realize and recognize 75x in capital gain and federal and State tax would be due on that amount.

Important Tax Compliance Tip: When property is transferred incident to a separation or divorce agreement, federal income tax regulations require the transferor to provide the transferee with detailed records that evidence tax basis and other tax attributes (holding period, etc.). Consulting with an experienced divorce tax attorney during a divorce will ensure that tax law requirements, like this one, are followed.

Considerations Regarding Interspousal Transfers

There are a few important considerations that taxpayers should bear in mind when they are transferring property incident to a separation or divorce. The first is when a transfer for property actually takes place. Although this element of Section 1041 is typically straightforward and the transfer is considered to be effectuated when one spouse physically takes possession of property from another, the technical test is when the “benefits and risks of ownership” pass from the transferor to the transferee.

The second consideration with regard to the transfer of property between spouses or ex-spouses is timing. The non-recognition treatment described above only applies if a transfer of property takes place between spouses or ex-spouses within either (a) 1 year of the dissolution of the marriage or (b) within 6 years of the dissolution of the marriage if the transfer of property is related to the dissolution. The last portion of (b) can be satisfied if the transfer of property is pursuant to a court order dividing marital property or is pursuant to a divorce or separation instrument. In determining whether a planned transfer of property between spouses or ex-spouses will receive non-recognition treatment under Section 1041, an experienced tax attorney should be consulted.

Dividing Property from a Tax Planning Perspective

Although a separation or divorce can be tough for both parties involved and it may be difficult for the former couple to work together, careful tax planning can be utilized to reduce the overall tax burden of both of the spouses. The ability to take advantage of Section 1041 allows taxpayers to shift property with significant amounts of built in gain to a spouse that will have a lower marginal tax rate after the divorce. Similarly, property with high basis can be allocated to a spouse that will be in a higher marginal bracket. A spouse that will end up taking on additional gain due to such tax planning could use their position to leverage additional transfers of property in the settlement agreement.