In some marital settlements, an inequitable division of community property may occur due to difficulty in splitting the shared assets. A cash payment from one spouse to the other can be required to balance an inequitable division of community property ordinarily where the community property estate assets cannot be split exactly in two or where an unequal division is contractually agreed to. This cash payment is nontaxable under 1041.
The parties are free to pay this amount over time and make whatever interest arrangements they choose. But beware — the IRS is likely to impute interest to the transaction under the holding in Craven v. U.S., (11th Cir 2000) 215 F3d 1201, if its omitted or at a less than market rates. Interest typically begin to accrue on the due date for the equalizing payment which is ordinarily the effective date of the martial settlement agreement.
Property settlements that result in large cash equalization payments in divorce are often paid over time in installments, with interest. However, a failure to fully consider the tax mechanics of an installment plan often results in additional, unexpected tax liability.
In Linda Gibbs, TC Memo 1997–196 and in Seymour v. Commissioner (payor) the tax effect of the installment interest was adjudicated. In Gibbs, the payee (recipient of the interest) attempted to argue that since she received the interest portion of the payment solely in exchange for property she transferred to her former spouse incident to a divorce, the interest, should be excludible from income under § 1041. The Tax Court held that the interest she had received gives rise to “separate federal income tax consequences,” and that § 1041 does not render the interest portion of the payments nontaxable.
In Seymour, the payor spouse attempted to argue for the deductibility of the interest portion of installment payments which the IRS had disallowed, arguing that § 1041 requires that the interest expense be characterized as nondeductible personal interest under § 163(h). The court held against the IRS and finding the interest to be deductible only to the extent that it could be allocated to a deductible expense such as qualified residence, investment or passive activity interest, under the Reg. § 1.163-8T tracing rules. So for example where a promissory note is executed by one spouse to a former spouse as an equalization payment for their ex’s ownership interest in community property transferred in a divorce settlement, to the extent the underlying debt is allocable to investment property, that portion of the interest would be deductible as investment interest.
Property transfers to a nonresident alien spouse or former spouse are by definition excluded from IRC Section 1041 and are therefore taxable events. This rationale for this exception is to avoid the loss of tax revenue that would occur if appreciated property were transferred to a nonresident alien spouse and then sold in a transaction without U.S. tax nexus.