IRC Section 1041(a) permits divorcing or separating spouses to transfer property between themselves without immediately recognizing a gain or loss as a result of the transaction. However, the spouse who receives the property takes a carryover basis, and does not receive a step-up in basis to the fair market value at the time the transfer is made. The often unforeseen tax trap here is that the spouse receiving the appreciated martial property will eventually have to pay tax on the built in gain of each asset that is subsequently sold. When the property is subsequently transferred or liquidated in a taxable transaction, the built in gain between the current fair market value at the time of the nontaxable transfer between the spouses under 1041 and the spouses adjusted tax basis can produce unexpected tax liability that if not planned for can effectively allocate a larger share of the marital estate to the spouse that planned for this contingency when agreeing to a split of the martial assets.
Whether a transfer between spouses will be nontaxable under 1041 in part depends on when the transferee spouse physically takes possession of the transferor spouse’s share of the community property and the associated timing of when the risks and benefits of ownership pass between the spouses. As described above, Section 1041(a) will apply when the transfer of property occurs within 1 year of the dissolution of the marriage. If the transfer of property is pursuant to a court order or a settlement agreement, the transfer can occur within six years of the dissolution and still qualify for nontaxable 1041 treatment.
Careful martial dissolution tax planning can minimize the overall tax burden that will eventually be borne by both spouses. However, a failure to account for the eventual gain to be realized on the inevitable subsequent dispositions of marital property can result in unforeseen tax liabilities, difficulties, and financial hardships upon subsequent distributions of martial property by either spouse. Generally, Section 1041(a) can be utilized to shift property with significant built-in gains to the spouse with a lower marginal tax rate to minimize future taxes. High basis property can be allocated to a spouse with a higher marginal rate. Furthermore, the knowledge and expectation that a spouse will face tax liability due to the liquidation of low basis assets can and should trigger negotiations for an additional share of marital assets in the final martial property settlement. Absent marital tax planning of this type and the associated effect on the marital settlement agreement negotiation process, a more equitable and tax advantaged allocation of marital property is seldom reached.