What Tax Consequences will I Face When My Property Was Previously Depreciated and then Transferred Incident to a Divorce?

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What Tax Consequences will I Face When My Property Was Previously Depreciated and then Transferred Incident to a Divorce?

IRC Reg. § 1.1041-1T(d) and Q& A-13, dictate potential surprising hidden negative tax consequences where a property has been previously depreciated under IRC § 179 and is subsequently converted to personal use following a § 1041 transfer. The transferee spouse, and her tax counsel, need to be aware that § 179(d)(10) and Reg. § 1.179-1(e), require the recapture of previous § 179 deductions where a business asset has previously been expensed under  § 179 is subsequently converted to personal use.

To illustrate, consider a scenario where H owns a business that utilized a Van for deliveries to customers for which he took a large § 179 bonus depreciation deduction on.  H transfers the car to W, under a property settlement agreement.  After removing all of the company graphics, W uses the Van for strictly personal purposes. Under 1041, H is not required to recognize gain, loss, or depreciation recapture on the transfer. To the horror of the transferee spouse, W is required to recapture the entire (or merely a portion) of the § 179 deduction previously taken by H, based on the period of time in which H utilized the Van in his business. The recaptured § 179 deduction will be ordinary income that will increase W’s basis in the Van, and help offset potential future capital gains if W subsequently sells the Van.

In order to avoid this absurd tax result, the Van should be sold and the proceeds transferred to W instead.