Real Estate and Divorce

By David W. Klasing Esq. M.S.-Tax CPA

Federal, State, Local and International Taxation Conference

Nov. 2 – 4 Universal City

Real Estate and Divorce – Topical Outline 

  • Learn the Common Roles CPAs Play in Divorce Scenarios involving Real Estate.
  • Learn the Basics Involved with Assisting your Client’s Divorce Counsel with Negotiating Settlement and Support Agreements.
  • Learn the Major Tax Implications that are Commonly Relevant in Divorce Scenarios.
  • Learn What Special Planning and Tax Implications Real Estate Raises in a Divorce Scenario.
  • Learn What Portions of a Divorce (if any) are Deductible by your Client.
  • Learn what Ethical Traps exist in Divorce Scenarios for CPAs and How to Successfully Mitigate them.

CPAs are often the most knowledgeable professionals in existence where the financial implications of our client’s lives are at issue.  For this reason, they are often requested to assist divorce counsel in resolving marital disputes surrounding financial issues in divorce scenarios especially where Martial Settlement and Support Agreements are at issue.  CPA’s need to know that performing in this capacity is not without risks surrounding potential ethical violations, especially pertaining to conflicts of interest.  Moreover, Real Estate is often the most valuable asset in a client’s marital property portfolio and carries with it a host of special tax and planning considerations in a divorce scenario. This class will enable CPAs to render paid services in a client’s divorce without engaging in the unauthorized practice of law or tripping on ethical violations. Moreover, Divorce Counsel are often hesitating to take responsibility for provided tax advice and planning in a divorce scenario.  This class will empower CPA’s to profitably and ethically assume that responsibility.

  • Introduction
  1. Property Distribution   
  1. California courts are generally mandated to divide the martial community property estate equally, unless the parties agree (settle) to an unequal division of property.  Under the holding in Marriage of Brewer & Federici (2001) 93 CA4th 1334, any division by agreement that is unequal must be “based upon a complete and accurate understanding of the existence and value of community and separate assets that are material to the agreement.” Fam C §§2551–2552 instructs the court to determine the character of the martial and non-marital community (Marital community or separate property of one or both the spouses) and to value the assets and liabilities included in the community property estate.

 

  1. Family Code §760creates a presumption of community property where by statute all real or personal property, regardless of location, that is acquired during marriage while living in California is community property. Under Marriage of Haines (1995) 33 CA4th 277, 289, this presumption can only be overcome with the presentation of credible evidence that the acquisition of the asset came from a separate property source. Fam C §2581 dictates that property acquired during marriage and held in joint form, i.e. tenancy in common, tenancy by the entirety or joint tenancy is also presumed to be community property.  Under Fam Code §2581(a), evidence that might effectively overcome this presumption could be where the deed contained an unequivocal statement that the property is intended to be separate property or where a written agreement exists delineating that the property is the separate property of one of the spouses.

 

  • Where a court determines that an asset is separate rather than community property, the court generally cannot assert jurisdiction over the disposition of the separate property. However, Family Code §2650enables the court to split out into separate property interests any real or personal property held as joint tenants or tenants in common, wherever it is situated and regardless of when it was acquired.

 

  1. Because of the above legal requirements, a central focus of the discovery process in divorce involves obtaining and documenting evidence necessary to determine the character of marital and non-marital property interests and classifying them as separate, community, or mixed. Evidence including the date of acquisition of an asset, its purchase price, the source of funds used to acquire, make improvements to, service any mortgage or debt incurred to finance the asset’s acquisition and acquisitions by gift or inheritance are relevant to making the necessary asset classification.   Executed Pre and Post marital, and estate planning documents that reference the martial or separate property at issue are also relevant.

 

  1. Payment to Balance Division

 

  • 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.

 

  • Installment Obligation & Property Distributions

 

  • Property settlements that result in large cash equalization payments in divorce are often paid over time in installments, with interest.

 

  • In Linda Gibbs, TC Memo 1997–196 and in Seymour v. Commissioner (payor) the tax effect of the installment interest was adjudicated.

 

  1. 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.

 

  1. 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.

 

  1. Transfers to Nonresident Alien Spouses

 

  • 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.

 

  1. CPA’s Role as Tax Advisor

 

  1. Tax Treatment of Property Transfers Subject to § 1041

 

  • A divorce ordinarily involves a transfer of cash or other property in exchange for the release of support or other marital rights as part of executing a marital settlement agreement. Under IRC Section 1041 the transfer of property between spouses or former spouses (if incident to divorce) is generally not treated as a taxable exchange. Confusing tax results can occur where the non-recognition rule of 1041 applies even where the marital parties are acting at arms’ length and full consideration is paid for the property. If 1041 applies, no step up in basis is received by the acquiring party in exchange for the consideration.

 

  1. Interplay of § 1041 and the Assignment of Income Doctrine

 

  • Section 1041 does not specifically address the tax treatment where a transferred asset, incident to a divorce, includes the rights to future income (e.g., the transfer of a bond or CD also entitles the owner to the accrued interest yet to be paid). Moreover, 1041 does not address the tax consequences of asset transfers involving the right to receive income (e.g. AR, contingent fees, and deferred compensation).

 

  • Ordinarily the taxpayer that earned income is taxed on it. However, where a taxpayer assigns an income producing asset, the tax liability on any future income stream shifts to the assignee. To reconcile between the non-recognition principles of § 1041 and anti-assignment of income principles, it is necessary to turn to administrative guidance and case law.

 

  • The IRS generally takes the position that income received subsequent to a transfer of a right to future income is taxable to the transferee. Any attempt by the transferee spouse to take the position that § 1041 makes the income nontaxable because there was a relinquishment of marital rights in exchange for it would be rejected by the IRS, unless the transferee spouse can establish that the income they received had already accrued while in the possession of the transferor spouse and therefore it is rightfully taxable to the transferor under general anti assignment of income holdings (consider accrued bond interest prior to the date the asset is transferred for example).  In Kochansky v. Commissioner the divorcing spouses agreed via marital settlement that they would share a contingent fee that was pending to the husband’s law practice. The Court held the portion received by the wife was taxable to the husband as it was non assignable personal services income via general anti assignment of income tax law principles.

 

  • Tax Preferred Retirement Benefits

 

  • Quite often one of the most valuable assets acquired during marriage are retirement plans like, deferred comp, IRA’s, Retirement plans qualified under ERISA, and similar tax-preferred benefits. Over time, Congress has enacted various statutory provisions to regulate the tax treatment of divorce generated transfers of future retirement and other tax preferred plan benefits to non-owner/participant spouses which override both the reach of § 1041 and general assignment of income principles.

 

  • ERISA generally dictates that retirement benefits cannot be assigned. However, a carve out to this prohibition exists in regards to divorce via a mechanism called a QRDO. Under ERISA § 206(d)(3)(B)(i) and IRC § 414(p)(1)(A) a “qualified domestic relation order” (QDRO) is a court order that carves out and recognizes the right to receive retirement distributions in the name of the spouse that did not earn the retirement funds at some point in the future. It assigns a right to receive, all or a portion of the benefits payable in regards to a retirement plan participant spouse to a non-participant spouse if the QDRO meets certain information and other requirements. A QDRO is ordinarily negotiated as part of a marital property settlement agreement. In order for a spouse to grant a share of a retirement benefit subject to ERISA to an ex-spouse, the terms delineated in the martial settlement agreement are required to comply with a myriad of requirements laid out in IRC Section 414(p). In addition Section 457deferred compensation plans for governmental and certain non-profit employees can also be qualified domestic relation order rules.  QDRO’s are not required for a divorced-based IRA transfer.

 

  • Division of pension plan befits planning considerations:

 

  • If one of the parties has creditor problems, it is important to realize that ERISA plans are generally not subject to creditor claims. The same is not always true of IRA although some states have enacted laws to provide creditor protection for IRAs.

 

  • If one of the spouses has health problems or believes because of their family healthy history, they will most likely live longer, and a defined benefit plan is at issue. By the healthier spouse retaining or being granted benefits under a QDRO, a greater lifetime financial benefit can be achieved and other assets from the martial estate can equalize the property distribution if necessary and if not a cash settlement and promissory note could be utilized.

 

·       Be careful that an IRA is not liquidated in order to give a divorcing spouse their ½ interest but rather a trustee to trustee transfer is utilized via a QRDO. In Bunney v. Commissioner – United States Tax Court, T.C. Memo. 2003-233 the Tax Court dealt with a vindictive spouse’s attempt to enjoy revenge against his ex-spouse in a divorce. After the court determined the wife was entitled to half of the husband’s IRA. The husband liquidated the IRA and paid 50% of the cash to his ex-spouse. The husband incorrectly anticipated that his ex would be legally responsible for both the income taxes and the associated early withdrawal penalty on the 50% of the distribution she received. To the surprise of the husband, the tax court held that the husband was responsible for the income tax on 100% of the funds withdrawn from the IRA and for the 10% early withdrawal penalty. The vindictive husband wound up paying all of the taxes and penalties, while his ex-spouse received an $111,600 tax free distribution from the IRA.

  • An Ex-spouse has two choice of methods to receive an ERISA benefit of a spouse under a QDRO. They can choose that any current distributions should be rolled into an IRA, or they can choose to leave the funds in the ERISA plan and draw upon those benefits in the future at retirement. In deciding which option makes the most sense, the following issues should be considered:

 

  • If the recipient spouse has creditor problems, staying with an ERISA plan benefit account would provide better asset protection.

 

  • If the participant spouse is not 100% vested in the ERISA plan, it is ordinarily financial beneficial to stay with an ERISA plan account until full vesting is achieved.

 

  • A comparison should be made of the historic and anticipated future rates of return and risks level encountered in staying with the ERISA plan and this same analysis extended to what is available in an IRA.

 

  • If the ERISA plan is sponsored by a family business that is controlled by the ex-spouse, the recipient spouse might want to consider rolling the plan benefits into an IRA to establish control over the benefits.

 

  • Gift and Estate Issues and Divorce

 

  • Unexpected gift and estate transfer tax issues can complicate a divorce or separation. The following issues should be considered.

 

  • 2523 Unlimited Marital Deduction for Estate Tax Purposes

 

  • Martial Property settlements must be negotiated and reviewed keeping a wary eye out for the unexpected imposition of a gift tax. While IRC Section 2523provides for an unlimited marital deduction for transfers between spouses during marriage, Transfers after divorce do not fall into this exception. Look to IRC 2516 and the following provisions for potential relief.

 

  • 2516 & Transfer Tax Relief in a Divorce Scenario

 

  • IRC Section 2516can provide gift tax protection for qualifying martial property settlements that are entered into after a divorce is finalized. 2516 exempts qualifying transfers from gift taxes where the transfer is for settlement of martial property rights, or child support obligations if:

 

  • The parties, whom are ex-spouses, enter into a written agreement that is not required to approved by any court.
  • Cash or property is transferred in settlement of spousal martial property rights or a “reasonable allowance” is transferred to support a minor child of the marriage. Neither the IRC nor the regulations define what constitutes a “reasonable allowance.” Presumably, any transfers in excess of a “reasonable allowance” would not be exempted from gift taxes under IRC Section 2516.
  • The written agreement must be executed within two years before the divorce and one year after the divorce. The transfer of assets is not required to occur within this same three-year period. Any modifications to the written agreement are also limited to the same three-year period. Lastly, if the transfer to an ex-spouse is voluntarily increased after the three-year period has run, IRC Section 2516will not apply, and the excess paid voluntarily may be required to be treated as a taxable gift.
  • IRC Section 2516does not require that the original divorce decree mention the subsequent written settlement agreement.
    • Judicial Exceptions to Impositions of Transfer Tax

 

  • Where IRC 2516 is unavailable, there may still exists a judicial exception to the imposition of gift tax on post-divorce transfers. For example, in Harris v. Commissioner, 340 U.S. 106, the U.S. Supreme Court ruled that divorce-related transfers ordered via a court decree are involuntary and, therefore, are not voluntary taxable transfers. The court reasoned that the relinquishment of marital rights in property under a settlement agreement that was conditional upon the granting of a divorce by a court which had jurisdiction to settle the property rights of the parties in a divorce proceeding constituted adequate and full consideration for the transfer of property so that no gift tax was applicable. While 20.2053-4 generally provides that any obligation imposed by law is a deductible debt of the estate, any property transfer agreements that are negotiated between the parties must be incorporated into the divorce court’s final ruling. If the divorce decree does not approve and incorporate the subsequent property transfer, the IRS could successfully argue that Harris is not applicable and thus the transfer would be taxable for gift tax purposes. Under the same reasoning, subsequent modifications of martial settlement agreements must also be approved by the court.

 

  • In situations where IRC Section 2516is not on point, another arguments lies with prior IRS guidance and court holdings that establish the premise that a release of support rights and child support obligations is “adequate consideration” to support a property transfer.  This however raises the issue of whether the consideration provided by each party was equal or not. If the decedent’s consideration provided was greater than the consideration received, the excess may not deductible for estate tax purposes. Lastly, property transfers related to marital settlements are not treated as adequate consideration as property distribution rights are not viewed as vested legal rights in a marriage.

 

  1. Transfer’s Between Spouses and IRC Section 1041

 

  • IRC Section 1041 applies to all transfers between spouses, whether or not incident to a divorce, even where the parties are not contemplating a divorce at the time of the transfer. IRC 1041 applies even where a divorce or separation never occurs. Transfers between spouses do not obtain the same tax treatment that would exist in an identical arm’s length transaction with a disinterested third party.  This can result in unexpected tax consequences.

 

Consider the following examples:

 

  • Prior to marriage, W buys an investment property for $200,000. W adds a car port costing $30,000. After W marries, H purchases a 50% interest in the property for $150,000 at which time the property had appreciated to a fair market value of $300,000. W recognizes no gain on the sale to H. H’s transferred basis from W for his 50% interest is $115,000 ($200,000 + 30,000 * 50%) even though he paid $150,000 to W. When the property is sold for $320,000 and both H and W receive $160,000, they each recognize a gain of $45,000 ($160,000 – 115,000).

 

  • Assume the same facts as above except that W’s fiancée purchases his 50% interest prior to marriage. W has to recognize a gain of $45,000 ($150,000 – 115,000) on the sale of a 50% to H. H and W both realize and recognizes a gain of $10,000 ($160,000 – $150,000) on the subsequent sale of the property for $300,000.

 

  • The tax effects of a sale of property / assets from a spouse’s sole proprietorship to the other spouse’s sole proprietorship is determined under § 1041(a) per Reg. § 1.1041-1T(a), Q& A-2 and thus no gain or loss is recognized and no adjustment to basis occurs. Contrast this with a sale between one spouse’s wholly-owned corporation and the other spouse’s wholly-owned corporation.  An unenlightened practitioner could potentially and understandably reason the sale between corporations would be taxed under general tax law principles and not §1041 and thus gain or loss would be recognized and basis would be adjusted under the theory that corporations are separate legal beings under the law from their owners.  Practitioner’s must be careful the taxing authorities do not subsequently take a “substance over form” approach to re-characterize the corporate transaction as in reality taking place between the two spouses and subjecting the transaction to the non-recognition mandate of § 1041.  Practitioners should also be wary of the subsequent application of the step transaction doctrine where for example an asset is first transferred to H’s Corporation and then sold to W’s Corporation.

 

  1. Transfer’s Before Marriage

 

  • Section 1041 does not apply to property transfers that take place prior to marriage. Accordingly, practitioners need to be on the lookout for a release of marital rights by a fiancée in exchange for a pre marriage property transfer under the terms of a premarital agreement which would not qualify for Section 1041 and thus could potentially be viewed by the taxing authorities as a taxable transaction. In stark contrast, a property transfer in exchange for the release of martial rights taking place after the couple’s marriage under a premarital agreement falls within § 1041 and thus is non-taxable.

 

  1. Section 1041 and “Certain” Transfers to Third Parties

 

  • Section §1041 specifically addresses solely transfers of property between spouses and former spouses and certain trusts for H and W’s benefit. However, the temporary regulations expand the reach of Section 1041 to “certain” transfers of property made on behalf of a spouse or former spouse to a third party, as if the transfer was directly between spouses.  A property transfer to a third party that is transferred on behalf of a spouse or former spouse will qualify for § 1041 treatment if one of the following three scenarios are on point as specified under Reg. § 1.1041-1T(c) and Q& A-9.

 

  • the third party transfer is mandated under a qualifying divorce instrument;

 

  • the third party transfer occurs following a written request of the transferee spouse; or

 

  • the transferor spouse obtains a timely written consent or ratification of the third-party transfer from the transferee spouse and must specifically state that the parties intend the transfer to be treated as a transfer between spouses qualifying under § 1041. The ratification will be considered timely if received by the transferor spouse before the filing of the transferor’s tax return for the tax year at issue.

 

Consider the follow examples:

 

  1. W has a parcel of land worth $100,000 with a basis of $20,000. Pursuant to a written request from H that qualifies under Reg. § 1.1041-1T(c) and Q& A-9, W transfers the lot to Vendor designated by H in satisfaction for H’s debt of $100,000 with Vendor. Under 1041, H takes W’s basis of $20,000 in the property and recognizes gain of $80,00 upon the transfer to Vendor. W recognizes no gain on the transfer to H.

 

  1. Assume the same facts as above except that the lot is instead gifted to X, H’s child as a gift. W recognizes no gain on the transfer to H under 1041. H takes W’s adjusted basis in the lot, which is transferred to X, under § 1015(a)’s carryover basis rules for gifts. Since a transfer by gift is not a taxable realization event for income tax purposes, H recognizes no gain as a result of the transfer but a gift tax return is required to be filed and gift taxes may be owed if H has used up his lifetime gifting exemption.

 

  • Transfers Occurring not more than One Year After Divorce and § 1041(c)(1)

 

  • Practitioners must be aware that under IRC § 1041(c)(1) and Reg. § 1.1041-1T(b), Q& A-6, apparently out of administrative convenience, any transfer that takes place within the first year after the marriage ends between ex-spouses will be governed by the 1041 non-recognition rules even where not factually related to the cessation of the marriage. Thus, IRC section 1041 non recognition provisions will apply even if the property that is transferred during the first year after marriage was acquired by solely the transferor out of separate property after the divorce was finalized. This can lead to unexpected tax results.

 

Consider the follow examples:

 

  • Eleven months after the entry of a final divorce decree, H sells W an original Rembrandt oil painting he inherited immediately after the divorce. H’s basis in the artwork is the $4,00,000 FMV of the art at the time of his relative’s death under § 1014(a)(1) which coincidently coincided with the finalization date of H and W’s divorce. The sale is in no way related to the divorce (except possibly in the way of revenge!!!). W pays $5,000,000 for the art. H recognizes no gain on the sale under the sale as dictated by 1041. Under 1041 W has a carryover basis of $4,000,000 irrespective of the $5,000,000 she paid to H. If she immediately runs into financial difficulty and then subsequently sells the painting for $5,000,000 she will recognize a gain of $1,000,000!  OUCH!!!

 

  • Assume the facts as above except that the transaction takes place one year and one day after entry of the final divorce decree. Since the transaction is not related to the cessation of marriage and occurs outside the one-year presumption period, H would recognize a $1,000,000 gain on the sale to W and W would have a basis of $5,000,000 in the painting.

 

  • Transfer’s Between Former Spouses Incident to Divorce

 

  • Section 1041 treatment applies to a transfer of property between former spouses if the transfer is incident to the divorce in either of the following two conditions:

 

  • the transfer occurs not more than one year after the date on which the marriage ceases; or

 

  • the transfer is related to the cessation of the marriage.

 

  • Neither the IRC nor the associated legislative history clearly defines the term “related to cessation of marriage” nor provides definitive guidance on whether § 1041(c) is to narrowly or broadly applied. The temporary regulations under § 1041(c) endeavor to provide some guidance.

 

  • A bright-line test exists for transfers that, occur after the first year following the finalization of the divorce (falling under § 1041(c)(1)), but within six years from the cessation of marriage (falling under § 1041(c)(2))

 

  • A transfer of property between former spouses will be deemed related to the cessation of marriage only if;

 

  1. the transfer is pursuant to an original, amended or modified divorce or separation instrument described in § 71(b)(2);

 

and

 

  1. the transfer occurs no later than six years after the divorce is finalized.

 

  • See reg. § 1.1041-1T(b), Q& A-7. For information on what constitutes a qualified divorce instruments under § 71(b)(2).

 

  • Per reg. § 1.1041-1T(b), Q&A-7, transfers are presumed for tax purposes not to be related to cessation of marriage if they don’t meet the six year or divorce or separation instrument requirements. This presumption can be rebutted with a showing that the transfer entered into in order divide property that was owned at cessation of the marriage between H and W.

 

  • Under Reg §1.1041-1T(b), the presumption can be rebutted with proof for example that legal, market or business complications prevented the transfer till after the 6-year period had run, or legal disputes between H and W as to the value of the property hindered the timely transfer, and that a reasonably prompt transfer transpired after the dispute or complication was removed.

 

  • Guidance provided by the IRS dictates that any order from a divorce court that modifies a divorce or separation agreement or judgement is required to be considered related to cessation of marriage, even if the modification occurs years after the divorce; and a subsequent transfer made to accomplish the division of property between ex-spouses, concerning property that existed at the time of the cessation of the marriage, is considered related to the cessation of the marriage.

 

  • In light of the above guidance, It’s best practices where drafting a qualified divorce instrument that provides for a transfer of property to occur more than six years after the date of dissolution to explain the reason for the delay.

 

  • In contrast, consider PLR 9306015 where the IRS took the position that the post six-year transfer presumption was not rebutted where a transfer took place over eight years after the finalization of the divorce and the court had not mandated the subsequent transfer.

 

Consider the follow example:

 

  • At divorce, H and W have a 9-year-old daughter. The divorce decree, citing the best interests of the Child, awards the use of the marital home to W and the daughter through her 18th birthday. At which time, the property settlement orders the sale of the home and the even split of the proceeds. The settlement provides H the first right of refusal option to buy out W’s interest in the family home. H exercises the option. The available guidance does not specifically call out child rearing as a justifiable intervening factor to rebut the post six-year presumption, however, it seems remote that the IRS would take the position that the subsequent transfer is unrelated to the divorce and thus the transfer from W to H should qualify for 1041 non recognition treatment some 9 years after the divorce. (but contrast with g below)

 

  • The term “cessation of marriage” includes annulments and marriages that are void ab initio due to violations of state law under Reg. § 1.1041-1T(c) Q& A-8.

 

  • A court order mandating the sale of marital property to a third party that further requires the sales proceeds to be divided between the spouses, is not considered to be “incident to the divorce” that would fall within the reach of § 1041(a)(2). Therefore, any inherent tax ramifications, including for example, gain / loss & ordinary income generating depreciation recapture etc., are required to be recognized by the spouse(s) on title to the asset that was sold in accordance with general tax principles.

 

Consider the follow examples:

 

  • In 2014 and 2015, H and W file married filing joint returns where they report Schedule E rental income and losses from Property P, which is titled solely in W’s name but which was acquired during the marriage with community property funds. In 2016, H and W get divorced. The marital settlement agreement appoints a third party trustee to sell Property P and then to divide the proceeds between H and W. W as the sole title holder of Property X, must report 100% if the gain from the sale although she only receives 50% of the proceeds.

 

  • Assume the same facts as above except that H and W have incurred suspended passive losses with respect to Property P due to having AGI in excess of $150,000 in 2014 and 2015. As a result of the sale, W is entitled to utilize the previously suspended passive losses subject to § 469.

 

  1. What Constitutes a Transfer of Property?

 

  • 1041 will not apply unless a “transfer” of property has occurred. Per the Tax Court, a “transfer” of property occurs at the earlier of the transfer of title or the shifting of the benefits and burdens of ownership between the parties. Ordinarily this is a non-issue but where the issue has been relevant, courts have cited the “benefits and burdens” test delineated in Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981).

 

  • Factors a court will look at to determine if a transfer has occurred as follows in determining if the Grodt benefits and burdens of ownership have passed between the parties;

 

  1. What was the parties’ intent with respect to the transfer?
  2. Who has legal title?
  3. What is each party’s equity in the property?
  4. Does an obligation to complete the transfer presently exist?
  5. What are the parties’ respective rights to possession?
  6. Which party is responsible for paying property taxes?
  7. Which party bears the risk of loss?
  8. Which party is receiving profits from the operation and/or sale of the property?

 

  • The Tax Court has stated that regardless if the transaction is a sale, exchange, gift, distribution, “the term transfer, at least in everyday parlance, connotes a physical delivery or divestment of legal title. In Skirpak, the fact that the petitioner never took physical possession of the asset at issue was also found to be irrelevant.  The court stated that it will look beyond bare legal title in determining if a “transfer” has occurred, but focused in on the right of a party to the beneficial enjoyment of the property at issue, and not the actual exercise of this right, that determines whether a taxpayer is to be recognized as the owner of property for federal tax purposes Skripak v. Commissioner, 84 T.C. 285 (1985).

 

  • Consider the following case:

 

  • The Grodt benefits and burdens test was applied in Berger v. Commissioner, T.C. Memo 1996-76. In Berger, H and W jointly owned a cemetery business which was awarded to W but H failed to execute the transfer documents until eight months after the date of dissolution. During the eight-month period H turned over control of the business activities to the cemeteries’ manager and W enjoyed the majority of the income generated by the business. Applying the Grodt benefits and burdens test, the court held the wife had legally obtained the equitable ownership of the cemetery business as of the date dissolution, and therefore W was required to recognize 100% (rather than 50%) of the gain on her sale of the business to an unrelated party.

 

  1. Treatment of Losses under 1041

 

  • The non-recognition treatment under §1041 applicable to gains is equally applies to losses where a transfer is subject to §1041. IRC § 1041(a) dictates that the transferring spouse recognizes no loss on the transfer of depreciated property (i.e. property with FMV less than book value) and the recipient spouse receives the transferring spouse’s adjusted basis in the asset, even where its basis exceeds its fair market value at transfer.  Note: This treatment is in direct opposition to the treatment accorded by 1015(e) to asset transfers via gift that limits the grantee’s basis in depreciated property to its FMV at date of transfer rather than its higher basis.

 

Consider the following Example:

 

  • W owns stock that she paid $100,000 for that has a current FMV of $90,000. W sells the stock to H for $90,000. W is prohibited under 1041 from deducting the loss, and H’s basis in the stock is $100,000 under 1041. When H later sells the stock to a disinterested third party for $85,000, he may recognize a $15,000 loss, subject to any then relevant loss limitation rules elsewhere in the IRC at that time.

 

  • Assume the same facts as in (a) except, instead, W makes a gift of the depreciated stock to H. The tax results are identical as the gift is governed by IRC 1041 not under 1015(e).

 

  • Assume the same facts as in (a) but instead this time W gifts the stock to H and W’s daughter and the daughter sells the stock to a third party for $85,000. The daughter’s deductible loss on the subsequent sale would be limited to $5,000. IRC § 1015(a) would limit the daughter’s loss basis to $90,000 which is the FMV at the date of the gift resulting in recognizable loss of $5,000 on a sale for $85,000 and an economic loss to the family of $15,000 ($100,000 less $85,000).

 

  • Treatment of Passive Losses Under 1041

 

  • IRC § 469, which dictates the tax treatment of passive activity losses, requires an exception to the above discussion regarding the general “transferred loss” provisions contained in § 1041.

 

  • IRC § 469(j)(6) requires that where an interest in a passive activity is gifted, any suspended passive losses related to the activity are non-allowable as future carryforward suspended passive losses but instead are added to the basis of the gifted property. This treatment trumps the loss treatment required under 1041 such that a recipient spouse of a passive activity property (e.g., rental property) may not claim as deductions the suspended losses accumulated by the transferor spouse and moreover of the couple, if joint returns were filed, with respect to the property.

 

Consider the Following Example:

 

  • A couple divorces and H transfers a rental property pursuant to a settlement agreement to W. For several previous tax years, they incurred and accumulated passive losses in the rental activity on joint returns.  Because the transaction is subject to 1041, W will be required to add 100% of the suspended passive losses to the basis of the property (H and W’s share) and will not be entitled to deduct the accumulated suspended losses on the transferred property even if she actively participates in the management of the property.

 

  1. Transferee’s Basis in Transferred Asset under § 1041

 

  • Per § 1041(b)(1), a transfer subject to § 1041(a) is generally accorded gift treatment to the transferee spouse for income tax purposes. Accordingly, the transferee spouse’s basis is generally the transferor spouses adjusted basis immediately before the transfer.

 

  • Basis not determined under the §1015 gift basis rules.

 

  • Transferee’s Holding Period

 

  • IRC § 1223(2) dictates that the transferee spouse receiving § 1041 property looks to the holding period of the transferor spouse in determining their holding period in the property.

 

  • Depreciation Recapture

 

  • IRC § 1041(b)(1) provides § 1041 transfers are treated as a gift for income tax purposes. Gifts of property do not result in depreciation recapture. Thus, a § 1041 transfer of depreciated § 1245 or § 1250 property via a property settlement agreement does not cause recapture of deprecation.  However, the transferee spouse steps into the shoes of the transferor spouse as to future depreciation recapture.

 

Consider the Following Example:

 

  • H acquires § 1245 property and then claims depreciation deductions related to the property in his business until the property is fully depreciated. W is transferred the § 1245 property via a property settlement. Even though W uses the asset for personal purposes the property is a capital asset in her hands. Because the property is personal and also is fully depreciated she may not claim further depreciation deductions. After holding the property for a month, she sells the property for more than H’s original cost. Because H fully depreciated the property prior to transferring it to W, under the recapture rules, the gain must be recognized as ordinary income to the extent of previous depreciation deductions claimed by H. Any proceeds in excess of the previous depreciation deductions taken by H are taxed as capital gains to W.  This tax result holds true even though the previous depreciation deductions were claimed by H and not W.

 

  • Change of Character of Section 179 Property from Business to Personal Between H and W Can Cause Surprising and Expensive Negative Tax Results!

 

  • 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.

 

Consider the Following Example:

 

  • 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.

 

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

 

  1. Stock Redemptions under § 1041

 

  • It is very common for closely held corporations for both H and W to be stockholders and officers of the corporation. In situations where it is necessary to redeem either H or W’s stock as part of a martial settlement, a determination is necessary as to whether or not a stock buy-back is on behalf of the spouse remaining with the business (acquiring spouse) or not. Where the acquiring spouse benefits because of the redemption of the redeemed spouse, the determination above generally turns on whether the acquiring spouse is being relieved of a primary and unconditional obligation to purchase his ex-spouse’s stock. Where a closely held corporation’s stock redemption is deemed to relieve the acquiring shareholder of such an obligation, the redemption may result in the imposition of a constructive dividend to them.  An ordinary stock redemption is a transfer of stock to the corporation in exchange for cash. In a deemed dividend scenario, under Reg. § 1.1041-2(a), § 1.1041-2(b), the transaction is viewed as the redeeming spouse first transferring stock to the acquiring spouse in a tax-free § 1041 exchange.  Then the acquiring spouse is deemed to have transferred the redeeming spouse’s stock to the corporation in exchange for cash. The deemed cash fictionally obtained by the acquiring spouse is treated as if were transferred to the redeeming spouse tax-free via § 1041.

 

  • Accordingly, the final § 1041 related to stock redemptions come in two major flavors, redemptions of stock 1. Resulting, or 2. Not resulting, in a constructive distribution to the acquiring spouse.

 

  • Under the default requirements dictated in Reg. 1.1041-2(a)(1), that are appropriate where the acquiring spouse is not benefiting by being relieved of a primary obligation to the exiting spouse, where a corporation redeems the stock of a spouse or former spouse, the exiting spouse’s receipt of property in respect of such redeemed stock is not treated under applicable tax law as resulting in a constructive distribution to the other spouse or former spouse (the “acquiring spouse”). In this scenario, stock redemption

 

  • treatment is respected and the exiting spouse is treated as having received a distribution redemption of stock and per Reg. § 1.1041-2(b)(1) the ordinary § 1041 non-recognition rules do not apply.

 

  • Where the acquiring spouse had an unconditional obligation to purchase the stock from the exiting spouse, Reg. 1.1041-2(a)(2) dictates that the exiting spouse’s receipt of redemption proceeds from the corporation is treated as a constructive distribution to the acquiring spouse.  The tax consequences of to the acquiring spouse related to the redemption proceeds received is determined under § 302.

 

  • § 1.1041-2(c) enables the parties to control which spouse will bear the tax consequences of the redemption via a written agreement by agreeing in advance which spouse will be treated for tax purposes as receiving the redemption distribution. The agreement must be executed before the date on which the agreed upon taxable spouse files his/her timely filed federal income tax return (including extensions).

 

Consider the Following Example:

 

  • A married couple’s corporation has 300 shares outstanding. At divorce H and W each own 150 shares. Under a martial property agreement H agrees to purchase W’s shares, and W agrees to sell her shares to H, in exchange for $100,000. The corporation redeems W’s shares for $100,000. Under local law, the agreement creates a primary obligation for H to purchase W’s stock, and thus the redemption results in a constructive distribution to H. W is treated as transferring her stock to H under § 1041 in a nontaxable transaction. H is deemed to have transferred W’s stock to the corporation in exchange for $100,000 in a taxable exchange that § 1041 does not apply to the taxability of which is determined under § 302.
  • While a complete discussion of the tax ramifications of stock redemptions is beyond the scope of this presentation, where a stock redemption occurs, §302(b) generally classifies it as either a stock sale taxable under §1001, or a dividend distribution where a corporation has sufficient earnings and profits available.
  • The determination of which of these two possible tax consequences result to the redeeming shareholder turn on whether the relative ownership percentage of the redeemed stockholder remains the same or significantly declines following the redemption. Where the relative ownership percentage remains the same, a deemed dividend results where it can be paid out of earnings and profits.
  • Where a stock redemption significantly decreases the relative ownership percentage or the redeeming shareholder, the stock redemption will be treated as a sale of stock, resulting in either a capital gain or loss to the redeemed shareholder, just as if the stock was sold to a disinterested third party.

 

  • Partnership Interests
    • Transfer of Right to Distributions
      • Most partnership agreements have anti-assignment provisions that prevent a partner from assigning their partnership interests to a non-partner third party. While at the same time most partnership agreements allow for the assignment of a partner’s right to distributions even where the party receiving the distribution is not technically a partner. Consequently, many marital settlement agreements require a transfer of a right to distributions between the spouses that is treated as a gift under Section 1041.

 

  • The holder of a mere right to distributions, as opposed to the holder of a complete assignment of a partner’s partnership interest, has a disadvantaged legal status under general partnership law that can only be somewhat mitigated by agreements between the former spouses.

 

  • A holder of a mere right to distributions is not accorded the rights held by a partner under general partnership law. As such they are not legally empowered to compel distributions, not owed the typical fiduciary duties a partner can expect from the other partners, and are not legally entitled to financial reports or granted the right to inspect the partnerships books and records.

Consider the Following Example:

 

  • H is a general partner of a Dental Group’s Limited Partnership. Although W is not a partner, the partnership interest is community property as H and W resided in California at the time the partnership was purchased up through the couple’s divorce. The partnership agreement contains a typical an anti-assignment clause that prohibits the assignment of H’s partnership interest but allows for the assignment of rights to distributions to a non-partner. As part of H and W’s marital settlement agreement, H was required to assign one-half of the annual partnership distributions related to H’s partnership interest to W, regardless if the distribution is paid out of profits or constitutes a return of capital. H and W would generally each be taxed on the income they each received related to the partnership interest at issue.
  • 1041 Tax Planning

 

  • An opportunity exists to use IRC § 1041 to achieve overall tax savings in situations where the ex- spouses are in substantially different income tax brackets, though assignment of income principles, or whom enjoy substantially different capital gain rates, through selective distribution of marital assets. In negotiating the martial settlement agreement and ultimately the division of the martial estate, H and W should be counseled to consider allocating to the spouse with the lower comparative capital gain rates the marital assets that have appreciated and thus are carrying built in gains. The spouse with the higher marginal capital gain rate should be allocated assets that have not appreciated or that have declined in value.

 

Consider the Following Examples:

 

  • W expects to sell depreciated stock that will generate a substantial capital loss following the divorce. To mitigate the $3,000 annual limitation on the deductibility of capital losses, H and W should contemplate transferring to W sufficient appreciated capital assets to absorb the anticipated capital loss.

 

  • W is historically subject to a higher marginal capital gain rate than H. To achieve overall tax savings where dividing the marital estate, appreciated property with built in gains should be transferred to H who should be taxed at a lower marginal capital gain rate, and W should be transferred built-in loss property.

 

  • Transfers Outside the Scope of § 1041

 

  • Section 1041 does not apply across the board to every possible transfer between spouses. The internal revenue code specifically contains exceptions that lead to transfers between H and W that do not qualify for 1041. Case law and IRS guidance continually defines and adjusts the reach and application of Section 1041. Where a transfer is removed from the reach of § 1041, the IRC may dictate the tax treatment that will apply to a transfer rather than the non-recognition (gift) provisions of § 1041. Where neither § 1041 and the IRC does not dictate alternative tax treatment, a common law doctrine might control.

 

  • Negative Basis Property

 

  • Transfers of Negative Basis Property to Trusts for the Benefit of an Ex-Spouse Incident to Divorce

 

  • While § 1041 would appear to apply to a transfer of negative basis property in trust between H and W or formerly married parties where the transfer is incident to divorce, § 1041(e) overrides the normal non-recognition “gift” treatment of 1041 and requires the transferor spouse to recognize a gain where the liabilities transferred exceed the adjusted tax basis of the property transferred in trust. The basis of the property funded to the trust is increased by any gain so recognized.

 

  • An exception to § 1041(e) appears to exist for grantor trusts. In PLR 9230021, the IRS opined that the grantor transferor spouse that remained fully taxable under § 674 was not required to recognize gain upon transferring a partnership interests that had liabilities in excess of the transferor spouses’ partnership basis to a trust he created for the benefit of his ex-spouse.

 

Consider the Following Examples:

 

  1. Via a martial settlement agreement, W transferred cash and a rental property that was her separate property owned prior to marriage into an irrevocable trust for H’s benefit in exchange for H’s release of future alimony payments. W’s adjusted tax basis in the property was $30,000 on the date of the transfer. The balance on the mortgage at the time of the transfer was $35,000. Under 1041(e), W must recognize a gain of $5,000 as a result of the transfer. The trust’s basis in the rental property is increased from $30,000 to $35,000.

 

  • Negative Basis Partnership Interests

 

  • Ordinarily when a partner’s allocable share of a partnership’s liabilities is greater than the adjusted basis of his partnership interest and he or she transfers this negative basis property to a third party a taxable gain would result. Such a transaction will receive non recognition “gift” treatment under § 1041 if between former spouses and incident to a divorce.

 

  • The same is true where only a portion of a spouse’s negative basis partnership interest is transferred between former spouses and incident to divorce.

 

  • Conclusion

 

  • As the content above demonstrates, careful planning as to whether a transfers of negative basis property to an ex-spouse outright or in trust will have adverse income tax ramifications is necessary, but it may be possible to plan and structure around potential income tax problems.

 

  • Investigating the Date of Separation

 

  • Making a legal determination of when a marriage terminates for tax purposes is the primary initial step in reaching the correct tax positions in a divorce situation. For tax purposes, per 6013and § 7703, H and W are married until they are deemed legally separated via either a final divorce decree or separate maintenance agreement. Per IRS Pub. 504, marital status is determined under State law and thus State law controls when the divorce decree or separate maintenance agreements become final.  A married filing joint or married filing separate return cannot generally be filed in the year that a divorce becomes final.

 

  • Unless a divorce decree or decree of separate maintenance is obtained by a taxpayer before the end of the tax year, they cannot qualify as an abandoned spouse and are considered married for tax purposes. A married filing joint or a married filing separate (MFS) return or head of household (in certain narrow conditions) is thus required.

 

  • Spouses that are separated under a temporary “interlocutory” decree of divorce are considered still married for tax purposes up and until a final decree of divorce is adjudicated. Where a spouse has appealed a divorce, state law determines if the appeal delays the effective final decree of divorce or not.

 

  • Per California Family Code §771 (a) once a spouse is separate and apart (i.e. after date of separation) their earnings are separate property and thus generally outside the purview of community property for purposes of property division.

 

  • Determining the correct date of separation is critical to the valuation of certain community property assets, i.e. business, assets and liabilities, whose values will ordinarily change over the course of negotiating or litigating the divorce which can have a significant effect on an eventual division of marital property.

 

  • A court in California will ordinary seek an objective basis for making a determination of H and W’s subjective intent to end their marriage. Of critical importance, as demonstrated in California Divorce Case Law, is when and if a physical separation occurred where one of the spouses left the marital residence.

 

  • Except for a narrow exception carved out in Marriage of Davis (2015) 61 C4th 846, 865, physical separation is an “indispensable threshold requirement” in a court determination of the official date of separation. According to the California Supreme Court to hold that a couple has separated requires that the spouses “live in separate residences and at least one of them has the subjective intent to end the marital relationship. A California court will look to evidence of the “subjective intent to end the relationship” that can be objectively measured “by words or conduct reflecting that there is a complete and final break in the marriage relationship”.

 

  • The Court is Davis did not rule out that there could be circumstances where a couple could be living ‘separate and apart,’ as if they had established separate residences with the requisite objectively evidenced intent by at least one of them to end the marriage, “even though they continued to literally share one roof.”

 

  • Under Marriage of Manfer (2006) 144 CA4th 925, 930, H or W’s subjective intent to separate is objectively scrutinized by a California court via examining the actions of H and W, and not by the perception of the public as to the status of the marriage, under the “preponderance of the evidence” standard.

 

  • Examples of Evidence to Establish Date of Separation

 

  • Joint credit card records evidencing duplicated living expenses especially the establishment of a separate residence
  • Written evidence of a party’s subjective intent to separate; Letters, Diaries, E-mails.
  • Credit card records of any new accounts opened after the purported date of separation
  • Change-of-address forms.
  • Real property lease outside the marital residence;
  • Bank records that show the opening of a separate bank account postdate of separation

 

  • Characterization of Real Estate

 

  1. Typical Interests Held in Real Property
  • Personal residences;
  • Raw land.
  • Vacation homes;
  • Ranches and Farms;
  • Commercial and domestic investment rental properties
  • Timeshares;

 

  1. Typical methods of holding title or owing California real property include:
  • Fee simple
  • Leaseholds,
  • Partnerships,
  • LLC’s
  • Corporations
  • Easements
  • Limited use interests (i.e. mineral, water, oil & gas rights).

 

  1. Tip: Relatively inexpensive public records databases are available to determine; all real property currently and formerly owned by H and W, how it was titled and any mortgage and lien holders.  Title reports can be ordered that will delineate the history of a property including all deeds that have been executed on a particular property in order to determine if any deeds were executed, such as a quitclaim deed, that may affect the characterization of a particular piece of marital property. Liens on the property can also be identified in the same manner that may affect the value of the property and effect if clear title can be obtained by a potential buyer.

 

  1. Documentary Evidence related to Real Property

 

  1. Documents needed to fully understand real estate ownership and transactions in a divorce scenario include:
  • Real estate purchase and sale contracts;
  • Pre or post marital agreements;
  • Rent rolls for all rental properties;
  • Documents to show acquisition of real estate including bank and brokerage account statements and check registers / cancelled checks
  • Loan documents – original loan & refinance documents, loan applications, promissory notes, and mortgages;
  • Co-tenancy agreements
  • Documentation related to any entity that owns real estate, including formation agreements, shareholder agreements, and trust agreements;
  • Documentation of any easement agreements, leases for the land and building or merely the use of land (i.e. oil and gas leases or water rights agreements), homeowners’ association agreements,
  • Home inspection reports, contracts and expense documentation surrounding remodeling and improvements, documentation of any insurance claims for loss or damage to property;
  • Documentation on the tax consequences related to the sale or exchange of property including tax returns
  • Appraisals and county assessor tax records;
  • Financial statements including P & L’s and balance sheets for all investment properties
  • Escrow statements and title insurance policies;
  • Real estate option agreements;
  • Property management agreements
  • Deeds including Quitclaim Deeds

 

  1. Tip: Under Rev & T C §69.5(g)(5), client’s that are 55 or older, that sell their family residence may be able to transfer all or a portion of their current California property tax basis to a new residence. The new residence generally is allowed to cost 5 or 10 percent more than the old residence, depending any delay in the sale of the old residence. This basis rollover is generally permitted where the replacement residence is in the same county as the old residence was.  A few California counties do not prohibit the replacement residence to be in a different county. In a divorce only one spouse has the right to roll over their property tax basis and thus it is advisable for this benefit to be negotiated within a property settlement agreement before a decision to sell the family home is made or the property tax basis roll over benefit can be lost or utilized by the other party in divorce without an offsetting benefit to the non-rollover spouse.

 

  1. TIP: If wither H or W is awarded the family residence as part of a martial property settlement, the tax advisor should advise their client regarding potentially negative tax consequences where the house is eventually sold at a later date. Under section 1041, the selling spouse is prohibited from adding to their cost basis any money paid or the value of other marital assets exchanged with his or her ex-spouse for their interest in the property. Under Marriage of Fonstein (1976) 17 C3d 738, 748, In California, a court will only take into consideration the “immediate and specific tax consequences” of a divorce. The future capital gain tax consequences of a later sale of a personal residence by the purchasing spouse are not deemed immediate and specific and thus the negative future tax ramifications will not be shifted by a California divorce court to the selling spouse. For this reason, it is advisable for the purchasing spouse to negotiate a purchase price that is reduced by ½ of the built in capital gain at the sale date at a minimum, and optimally by ½ of the projected future capital gains if possible taking into consideration the section 121 exclusion available to the acquiring spouse available at the future sale date.

 

  1. It is H or W’s individual claims in a divorce that drives the amount and type of documentary evidence that is needed to support it. For example, if H claims a separate property interest in an investment property acquired before marriage, because the marital community serviced the mortgage during the 20-year marriage and made substantial improvements to the property with CP funds, A Moore-Marsden-Frick community property interest is also created. The attorney or the CPA assisting them will need to obtain any pertinent documentary evidence listed above, as well as potentially these other records:

 

  1. Documentary evidence of the following:

 

  1. Any change in title or ownership interest percentage over the marriage, by deed, pre or postnuptial transmutation agreements;
  2. Appraisals or other evidence to establish the investment property’s value at or near the date of marriage, or on the date of any change in title, and at the date of the divorce;
  • Evidence of the principal balance on the mortgage at date of marriage, date of separation, and the balance due at date of dissolution;
  1. Canceled checks, check registers, and bank statements that prove the amount and source of funds used to service the mortgage and or to make the improvements to the property over the marriage;

 

  1. Tip: If the real estate at issue is indeed found to be mostly separate property but H and W historically filed joint tax returns over the marriage, the marital community enjoyed the tax benefits from the mortgage interest payments, property taxes and depreciation, the attorney or CPA assisting them might want to argue that the separate property of the owner spouse is entitled to a reimbursement for these benefits if serviced with Separate Property Income.

 

  1. Separate Property

 

  1. After Acquired Assets

 

  • California Family Code §771(a) dictates that assets acquired after the date of separation are generally the separate property of the acquiring spouse.  Both H and W need to advised of this fact.

 

  1. Community Property

 

  1. Post Separation Payments with Separate Property Towards CP Asset (Epstein)

 

  • Epstein Credits and Watts Charges

 

  • Epstein credits 

 

  • In California, Marriage of Epstein (1979) 24 C3d 76, dictates that post-separation payments out of the separate property of either H or W towards the community property assets or liabilities requires the separate property of the payer spouse to receive reimbursement unless:

 

  • Exceptions:

 

  1. an agreement between H and W provides otherwise;
  2. the payment was intended as a gift;
  3. the spouse making payment made use of the asset for which the separate property funds were expended;
  4. or separate property payments were expended in relation to a valid spousal or child support obligation.

 

  1. The rational is that reimbursement in the exception situations specified above would be inequitable, as the paying spouse received a benefit, and as such, their spouse should not be legally obligated to compensate the payer spouse.

 

  1. The most common Epstein reimbursement fact patterns involve post separation payments of community property debts, and to a lesser extent, separate property improvements of community property assets. See Marriage of Reilley (1987) 196 CA3d 1119, 1122 for an example.

 

  • Watts charges

 

  1. In California, Marriage of Watts (1985) 171 CA3d 366, dictates that the martial community may be owed reimbursement where one spouse makes exclusive use of a community property (CP) asset after the date of separation through the date of marital dissolution.  Establish the “use value” of the asset at issue is the central determination leading to a Watts charge, and arriving at a value turns on the nature of the individual CP asset.

 

  1. Commingled Assets and Accounts

 

  1. Under Marriage of Braud (1996) 45 CA4th 797, 822, when SP and CP funds are spent to acquire a CP asset or to open a joint bank account, the funds or acquired asset becomes commingled. The character of the commingled funds or CP Asset, is not substantially affected however, where the respective SP and CP contributions to the purchase of the commingled asset or deposit to the commingled account can be traced back to the source of funds used to acquire the commingled asset or open the commingled account. Under Fam C §760, If the SP versus CP source of funds is untraceable, the overriding presumption that all property acquired during marriage in California is community property will control and thus the commingled assets or accounts will be classified as CP.

 

  1. Under Marriage of Braud (1996) 45 CA4th 797, 823, a H or W that seeks to prove a commingled asset or account was at least partially acquired with SP funds bears the burden of proof and must provide “substantial evidence” to the divorce court in order to prevail on his or her position and overcome the CP presumption.

 

  1. Direct Tracing

 

  • Direct tracing involves proving the separate property contribution to a commingled account or asset by tracing its acquisition or funding back to a separate property source and then tracing forward to where the separate property funds were utilized to purchase a particular asset or deposited to a commingled account.

 

  1. Family Expense Tracing

 

  • Under See v See (1966) 64 C2d 778, 783, the only available method of proof in California, other than direct tracing, is family expense tracing, via which the spouse attempting to prove a separate property contribution towards a commingled asset or account must be able to prove that any available community property funds were fully exhausted at the time a commingled asset was purchased, a payment was made, or a commingled account was opened, and thus separate funds must have been used to make the disputed purchase or payment. They must also be able to prove that the separate property funds utilized were theirs.

 

  • Family tracing evidence will not be admissible to attempt to show that community expenses exceeded community income over the marriage in an attempt to argue for a separate property reimbursement as it must have been used to cover community expenses.

 

  1. Contributions of Separate Property Towards a Community Property Asset

 

  1. Fam C §2640(a) creates a right to reimbursement where separate property funds are used to acquire a community property asset. Separate property funds used for down payments, improvements, and principal payments on a loan used to finance the purchase of community property assets are reimbursable. Separate property funds used to pay loan interest as it becomes due, or for maintenance, insurance, or taxation of a community property asset are not reimbursable.

 

  1. Under Fam C §2640(b), the party who utilizes separate property funds to make the above types of contributions to the marital community will ordinarily receive a reimbursement for such expenditures in a martial settlement if a separate property source can be proven, unless the right to such reimbursement was waived in writing.

 

  • Separate Property Contribution towards a Community Residence

 

  • In addition to ½ of the community property that the spouse whom contributes separate property towards a community residence would otherwise receive they will also be entitled to a reimbursement from the noncontributing spouses ½ of the community property for the total provable separate property contributed towards the community residence. This separate property reimbursement can by agreement also be paid out of the proceeds on the sale of the community residence.

 

  • No right to reimbursement if separate property contributing spouse made a written waiver of the right to reimbursement or signed any type of a writing that has the legal effect of such a waiver.

 

  • Fam C §2640 does not provide for reimbursement of interest or for any adjustments or changes in fair market value of the community residence and the reimbursement may not exceed the net value of the property at the time of the marital property division.

 

  1. Separate Property Contribution to the Separate Property of the Other Spouse

 

  • Under Fam C §2640(c), a spouse is entitled to reimbursement where his or her separate property was contributed during marriage to acquire separate property of the other spouse, as long as he or she did not waive in writing the right to reimbursement and or a transmutation agreement was not in place that would legally alter this default result.

 

  1. Premarital Separate Business

 

Under, Fam C §752 and §770, a premarital separate property business generally remains the separate property of the spouse that started the business.  Generally, in the absence of a transmutation agreement or where community and separate property have been commingled, spouses do not have an interest in the other spouses’ separate property.  If however, the value of the separate property business appreciated over the life of the marriage (date of marriage to date of separation) due, at least in part, to the separate property spouses’ efforts, skills, or talent, which are community property assets during the marriage, the marital community will acquire an allocable portion of the increase in value attributable to the separate property spouses labor during marriage.  For a better understanding of this concept see Beam v Bank of America (1971) 6 C3d 12, 17Patrick v Alacer Corp. (2011) 201 CA4th 1326, 1339.

 

  • Pereira / Van Camp Apportionment of Interests Method

 

  • Where the value of a closely held separate property small business, regardless of the entity choice utilized, appreciates during marriage at least partially due to the community property efforts of the separate property spouse, the increase in fair market value attributable to the CP labor of the separate property spouse requires apportionment between both spouses. Determining the amount requiring such apportionment is ordinarily determined using either the Pereira or Van Camp approach, or a combination of these valuation methodologies. The choice of which approach to use turns on what is viewed to have caused the increase in fair market value over the life of the marriage.

 

  • A court utilizing either Pereira of Van Camp will first attempt to establish the fair market value of the business at the date of marriage which is wholly allocated to the separate property spouse. This is a great reason to advise couples contemplating marriage to get a valuation of their separate property businesses close to the date of marriage.

 

  • The Pereira approach originated in Pereira v Pereira (1909) 156 CA 1. A court utilizing the Pereira approach will determine a reasonable rate of return expected for the type of business at issue and allocate it along with the value of the separate property business at date of marriage to the separate property business owner spouse.  Any remaining increase in Fair Market Value achieved over the life of the marriage is allocated to the community property martial estate.

 

  • The Pereira approach will be utilized where a court believes the appreciation in the value of a business over the life of a marriage is mostly due to the skills, efforts and talents of the separate property business owner spouse.

 

  • The Van Camp approach originated in Van Camp v Van Camp (1921) 53 CA 17) where a valuation expert first determines the reasonable value of the separate property spouses’ labor reduced by the value of any direct or indirect compensation received during the marriage, and then allocates this additional sum, if any, to the marital community with the balance of any increase apportioned to the separate property spouse.

 

  • The Van Camp approach will be utilized by a court where the majority of the increase in fair market value of the separate property business over the life of the marriage is believed to be related to factors aside from the community efforts of the separate business owner spouse, like the economy, the capital invested in the business or the type of the business itself, market timing, expertise and value of the management team and or the large number of contributing employees, the community estate gets awarded for what the separate property spouse might have been paid for similar work with any remaining increase in FMV being allocated to the separate property of the business owner spouse.

 

  • In light of the above, the three most important valuation dates in assisting client and divorce counsel in valuing separate property businesses in divorce scenarios are (1) the date of marriage, (2) the date of separation, and (3) the trial date.

 

  • TIP: Be on the lookout for closely held owned businesses that have been fraudulent in understating the income of the business. Where fraud, unexplained errors, or potential illegal acts are suspected, special care needs to be undertaken. A divorce attorney or a CPA would be practicing beneath the standard of care by blindly accepting client representations or representations made by management via company financial statements where they indicate potential material irregularities. Accounting irregularities can involve the understatement or omission of income and can involve a second set of books or accounts that are not reflected in the accounting for the business. Divorce Counsel and those assisting them, should take extreme care to take into consideration the potential criminal tax implications inherent is such a scenario. A business owner spouse has a fiduciary duty to disclose their own illegal actions to their spouse in order to protect the marital community. Any breach of this duty gives rise to potential additional causes of action. Divorce counsel that suspects “irregularities” will often consult with CPA’s from the outset of the divorce action. CPAs should be on the lookout for conflicts of interest, between the spouses and between themselves and the client if fraud is found to have occurred in a return that the CPA prepared.

 

  1. Effects of Pre or Post Nuptial Agreements / Transmutation Agreements

 

  1. Discussing the possibility of divorce with a couple before a divorce is even remotely on the horizon, preferably while the couple is beginning to contemplate marriage is often advisable for high net worth clients. Planning at this stage of the relationship for the eventuality of a possible divorce is commonly believed to be the least stressful time to do so. With a wedding on the near horizon this often leads to a spirit of cooperation and each party is ordinarily more apt to be willing to compromise and negotiate reasonably, where by comparison, the same cannot be said during a subsequent period of marital strife. The negotiate of a post marital agreement, is often, for this reason, met with antagonism which can be exasperated based on the course of the marital relationship to that point.

 

  1. Premarital agreements are extremely popular as tool to address the inherent financial risks associated with a divorce. The most common scenarios that create the need for a premarital agreement include: couples that are possess disparate amounts of wealth, (2) one party does not intend to work, (3) the parties bring disparate amounts of debt to the union, (4) children exist from a previous marriage, (5) previous experience with a contentious divorce, (6) one party owns a business before marriage or owns an interest in a family business and (7) there are large anticipated inheritance, (8) one party owns a family home. In any event a premarital agreement is an excellent tool to legally pre define property expectations and rights in the event of a divorce which enables the couple to alter the default community property statutory scheme in the event of a divorce and put in place a specific plan that is appropriate to their customized circumstances.

 

  • A premarital agreement functions by enabling the parties to pre-characterize their current and expected future property, and any related income streams, as either non-marital or marital. In California any non-marital property will not be considered part of the marital estate at divorce and thus will not be subject to a community property interest or allocation in the event of a divorce.  The two most common classes of non-marital property protected via a prenuptial agreement are (I) property acquired by gift or inheritance before and or during the marriage, and (2) property acquired by one of the parties before marriage and the party that owns it does not wish to convert a portion of the property into co-ownership with a new spouse. In the absence of a premarital agreement, marital property is ordinarily defined as all assets owned by either spouse during marriage or at divorce.

 

  1. Enforceability of Premarital Agreements

 

  1. Early premarital agreements often received adverse treatment by the courts on the theory that they were against public policy because they were seen to facilitate, encourage and or foster divorce. Over time as the divorce rate rose to record levels the courts and to some extent state legislatures began to recognize premarital agreements as positive because of their ability to unclog the courts dockets that were bogged down with numerous and time consuming contentious divorces. Consequently, at present, many jurisdictions explicitly authorize couples enter these contractual agreements as long as they are drafted in a businesslike manner and are negotiated in an arm’s length manner in which both parties reach and informed determination of their rights in a divorce in relation to one-another.

 

  1. To date greater than half of the states have adopted the Uniform Premarital Agreement Act (UPAA) with no or only minor modifications. Consequently, under the UPAA, premarital agreements are presumptively valid and enforceable. Thus a party attempting to invalidate a prenuptial agreement is faced with bearing the burden of proof in attempting to do so.  Successful grounds to set aside a prenuptial agreement are where it is held to be unconscionable and or where the nondisclosure of property or debt obligations negatively affected the complaining party. Even where consideration is found lacking at the time of execution, the agreement will be enforceable if it is signed by both parties under the UPAA.

 

  • All though states differ on this, three criteria generally apply in order for a court to find a prenuptial agreement valid; (1) the agreement must not have been obtained via fraud, duress, mistake, misrepresentation, or where a material fact went undisclosed, (2) the agreement cannot be deemed to be unconscionable at the time of execution, (3) Changing circumstances over the life of the marriage must not render current enforcement of the premarital agreement unfair or unreasonable.

 

  1. California reviewing courts will ordinarily focus their analysis on compliance with procedural requirements spelled out in the UPAA and in California case law and also the substantive fairness at date of execution and at dissolution. Grounds to attack a premarital agreement include that is was executed under duress, one spouses lack of knowledge regarding the contract terms because of the non-disclosure of the other party, overreaching, and unconscionability. An outright or implied threat to not proceed with the marriage, even if a party is pregnant, will generally not constitute duress in and of itself. The Statute of limitations on bringing a claim for duress generally begins to run at the date the agreement is executed, and a claim of duress will not be valid unless the claim is asserted timely. Moreover, a party’s failure to read the agreement fully and the associated lack of effort at understanding the agreement will not provide grounds to declare as void the agreement.

 

  1. Courts will ordinarily predictably refuse to enforce certain contract provisions. Generally, attempts to contractually regulate the frequency of sexual relations, allowable number of in-law visits, and provisions limiting child support will not be enforced. Contract provisions that have recently been enforced are the valid period of the contract, predeterminations regarding the division of property, income, debt, spousal support (as long as does not exclude entirely) agreements regarding the children’s surnames, use or nonuse of birth control, required housework, place of domicile, religion of the children, agreements as to will provisions and whom will inherit what and what circumstances will warrant dissolution of the marriage.

 

  1. Need for two Attorneys where a couple is executing a Premarital Agreement

 

An Attorney representing a party in negotiating and executing a premarital agreement is required to be completely loyalty to the best interests of a single party, especially in light of the fact that their party’s best interests are most likely in direct opposition to the best interests of their client’s future spouse. Attorneys, like accountants, are prohibited from representing a client whose interests are in direct opposition to the interests of another client or where their representation would be material limited by the representation of another client.  For the same reason, one accountant should not be utilized to provide assistance to both parties during the negotiation / execution of a premarital agreement.

 

Attorneys, like accountants, can still render services after informed consent via a conflict waiver is obtained regarding the potential conflict of interest from both clients.   However, separate representation is still strongly encouraged as representation of both parties after informed consent is obtained will invariably result in the risk of the escalation of the potential for a conflict to the development of an actual current conflict, which would place the attorney, and CPA representing both parties in an ethical quagmire, which could open the door for either contract party to challenge the enforceability of the premarital agreement at some point in the future.          Even where an Attorney or CPA is only representing one party, the emotional fireworks the couple can experience while negotiating and executing a premarital agreement can take the parties by surprise and thus Attorneys and CPA should proceed with abundant caution.

 

Reviewing a premarital agreement for enforceability

 

Often, the most challenging aspects by Attorneys in drafting premarital agreements turns on the fact that it is a virtual impossibly for the drafting attorney, (CPA should never attempt this as it is the practice of law), is that it is impossible to anticipate all the possible actions the couple may could take over the life of the marriage.  Endless variables surrounding the couple’s decision to have children, and if so, how many, to have a career or to stay home and raise children, the potential for future inheritances, complicate the drafting process as does drafting for any potential future direction the law may evolve to by the time a party actually seeks to enforce the agreement, which can occur and any point in the future.  Quite often, a party that attacks the validity of the premarital agreement, argues the agreement is unfair in light of a current set of circumstances that was not anticipated at the time premarital agreement was drafted. It is generally an impossibility to draft away every potential set of grounds for future challenge of a premarital agreement due to the unpredictable and uncontrolled set of future circumstances that can arise between a couple over the life or a marriage, certain drafting approaches have been shown to reduce the potency of a future attack on a premarital agreement.

 

In light of the above admitted drafting difficulties is not recommended for an Attorney to try and draft a specific provision for every potential set of future circumstances but rather attempt to draft the agreement in a manor where it evolves over time via referencing to contingent or specific external factors, in a manner that provides a flexible structure that will hold up to the test of time.  One manor to address these concerns is to draft the agreement so that it will cease to exist in response to contingent or specific circumstances, including quite often the mere passage of time. Another manor to address the same concerns for estate purposes can be to increase the surviving spouse’s share of the decedent’s estate over time.

 

Here is a list of the most common drafting problem areas in drafting premarital agreements:

 

  • Agreement does not properly define property owned before marriage to be held as separate property or does not protect against the future inadvertent commingling with marital community or outright conversion to community property.

 

  • This problem often involves the primary residence where it is common for both parties to contribute a portion of their salaries to the continuing mortgage payments on the martial home that was separately owned by one party before the marriage. Consequently, the premarital agreement must clearly address existing equity at marriage, future separate or community contributions to reduce any indebtedness existing at the date of the marriage, make routine repairs and maintenance or to make major improvements during the marriage and it must provide for the future appreciation in value. The desired use and ultimate ownership of the property at the date of separation and divorce must also be clearly defined.
  • In the event of the spouse on title to the family home dying first it is important to clearly draft for any desired life estate for the surviving spouse and to define how any continuing mortgage, property taxes, and maintenance will be provided for. The eventuality of the survivor spouse needing to move or be placed into a nursing home should be contractually anticipated. The premarital agreement should be coordinated with the client’s estate plan to ensure that they are not in conflict or ambiguous, which could lead to estate litigation.
  • To enable the premarital agreement to be controlling in event of the death of a spouse as well as divorce, it must provide for a waiver of a current or future spouse’s rights under California law against the estate of the deceased spouse. The waiver may specific to the real estate or a general waiver as to a clearly defined category of separate property.

 

  • Agreement does not address the future growth of assets owned as separate property before marriage. The agreement must clearly define whether future appreciation in value and or the income generated from separate property will be marital property or separate property. Failure to define for these eventualities can put the client in a position where they are faced with the nearly impossible task of tracing the assets at date of dissolution back to premarital property, which may be several decades later. Clearly defining what is and is not separate property is important at death or divorce. One effective method to address this problem is to attach to the premarital agreement a schedule of each party’s separate property at date of marriage, which will serve as a reference if tracing ultimately becomes necessary. The filing of married filing separate tax returns after marriage can reinforce the separate property designations at marriage.

 

  • For estate purposes, the agreement does not avoid the possibility of creating protracted litigation over defining community marital property versus separate property by including a clause that neither spouse will contest the other spouse’s will. To allow for the flexibility that a subsequent bequest to a spouse in the other spouse’s will may amend or supersede the premarital agreement even in the absence of a written modification of the premarital agreement consented to by both parties, the premarital agreement should include a provision that an implied waiver of spousal rights in a premarital agreement does not legally prevent a spouse from bequeathing a greater share of their separate property or marital property than is required under the premarital agreement, and neither does any such implied waiver or rights under a premarital agreement prevent the surviving spouse from legally accepting any such bequest.

 

  • Real Estate and Marital Property Settlement Options

 

  1. The pension benefits that have accrued over the marriage to either party and the equity in the marital home are often the most valuable marital assets at divorce. As part of a martial settlement agreement one spouse may convey his or her ownership interest in the marital home to the other spouse. In the alternative, the martial home may be required to be sold to a third party at dissolution or postponed to a later date which is often when the youngest child turns 18. Between dissolution and the subsequent sale date one spouse and the children ordinarily continue to live in the marital home.

 

  1. Five different settlement options for disposition of the martial home are potentially available, depending on each couple’s individual facts and circumstances. They include:

 

  • Interspousal Cash Sale,

 

  • As discussed fully developed above, under IRC § 1041 If one spouse sells his or her interest in the marital home to his or her spouse “incident to the divorce,” no gain or loss is recognized upon the sale. The purchasing spouse does not get a step up in basis related to the purchase price paid.

 

  • Interspousal Promissory Note,

 

  • An interspousal sale is appropriate in circumstances where one spouse wants the family residence but insufficient community property assets exist to provide the other spouse with an equitable marital property division. The acquiring spouse ordinarily uses his or her separate property to purchase their spouse’s share of the couple’s equity in the home. A common complication arises where the existing mortgage holder insists that the existing mortgage be full paid off under a common “due-on-sale” clause where it discovers the pending or subsequent transfer. If the acquiring spouse may have difficulty paying off the existing mortgage without first obtaining alternate financing, the spousal sale can be made conditional on him or her first securing adequate financing.

 

  • Promissory note is being considered it is important that there is sufficient equity in the family residence to secure the debt obligation. Title insurance is also advisable to define and protect the priority position of the deed of trust in the event of foreclosure.

 

  • Sale to a Third Party,

 

  • Continued Joint Ownership Pending a Deferred Sale,

 

  • The most common reason a differed sale is contemplated is where there are insufficient other community property assets available to be able to award the residence to one spouse as part of an equitable and fair marital property division, and a sale between the spouses may be an economic impossibility.
  • Note: Where a deferred sale is agreed to or ordered by the court the court order should specifically prohibit the non-possessory spouse from living in the residence in order to enable a full section 121 exclusion when the home is ultimately sold that is available under IRC §121(e)(3)(B).

 

  • Consideration where a differed sale is contemplated:

 

  • Which party, H or W, will have exclusive occupancy until what event occurs?
    1. Potential events to tie a differed sale to: (ordinarily multiple events are listed)

 

  1. The date of _________ arrives.

 

  1. A child of the marriage reaches majority or finished college

 

  1. The occupant spouse dies, remarries or a romantic partner of occupant spouse uses the residence as his or her principal residence.

 

  1. The residence is condemned, destroyed, or damaged beyond where feasible to repair.

 

  1. A party fails to service the mortgage and it goes into default or the lender takes action to force a foreclosure or short sale

 

  1. The parties mutually agree to sell the residence.

 

  1. One or both parties can be given the right of first refusal to purchase the residence by paying the other spouse his or her proportionate share of the equity at the sale date and at what time in the future or on the occurrence of what specified events will the right of first refusal vest?

 

  1. Equity for this purpose is often defined as the fair market value of the residence at the contemplated sale date, less the purchasing party’s share of any encumbrances.

 

  1. Note: Be careful with the passage of significant amounts of time where a right of first refusal is granted and then subsequently exercised. A taxing authority may question whether the deferred interspousal sale per the first right of refusal still qualifies as “incident to” dissolution and, therefore, the sale might be considered a taxable event instead of non-taxable under IRC § 1041.

 

  1. Consideration of Maintenance, Repairs, and Improvements During Period of Joint Ownership Pending a Sale

 

  1. During the period after separation while the divorce is pending and before the ultimate sale of the residence, the parties or the divorce court will need to determine which party, or if the parties share responsibility, in what ratio will the parties be responsible for the mortgage payment, property taxes, maintenance, property insurance.

 

  1. An advisable clause in any agreement or court order addressing this issue, is that Neither party is legally entitled to further encumber the residence without the other’s party’s prior written consent.

 

 

  • Awarding the Residence to one Party as Part of an Overall Equitable Division of Community Property

 

  1. Effect of Children on Determination of Who Gets the House
    1. Best Interests of the Child Standard

 

  • A divorce court under, Fam C §3800 and Marriage of Braud (1996) 45 CA4th 797, 809, may order a deferred sale of the family residence, even where the residence is the separate property of one of the spouses where it deems necessary to maintain stability for the children living in the home and to minimize the adverse impact of dissolution of marriage or legal separation of the parties on the welfare of the child.

 

 

  1. Relief from Liability on Sale of CP can be Denied Despite Lack of Financial Benefit to one of the Spouses

 

  • Under TC Memo 1991-40PH TCM ¶91040 61 CCH TCM 1767 a taxpayer’s spouse whom did not receive any of the proceeds on the sale of a community property real estate by the taxpayer while a divorce action was pending was held liable for ½ of the capital gain on the sale.  The taxpayer reported ½ the capital gain on the sale on his married filing separate tax return.  The taxpayer’s spouse had knowledge of the sale occurring prior to the execution of a martial property settlement and before filing her married filing separate tax return for the year the sale occurred. She took the position that since she did not receive any of the proceeds of the sale she was not required to report her ½ of the capital gain. The Service attempted to asses her on 1/2 the capital gain. The taxpayer’s attempted to fight off the assessment arguing that the provisions of IRC § 66 applied where the individual live apart at any time during the taxable year, do not file a joint return, and no portion of the proceeds were transferred directly or indirectly between such individuals before the close of the tax year then community income taxed to the party that earned it.

 

  • The tax court held for the commissioner stating that Section 66did not apply because taxpayer had knowledge of the item of income which killed the relief provisions of Section 66(c) (see below) and the real estate was not the spouse’s separate property which would have made it taxable to solely the taxpayer on a married filing separate return. Author’s Comment: Also relief was not available under 66(a) as sale of CP real estate did not meet the definition of earned income specified in 911(d)(2) – i.e. wages, salaries or professional fees.

 

  • Section 66(c) Spouse relieved of liability in certain other cases

Under regulations prescribed by the Secretary, if—

  1. an individual does not file a joint return for any taxable year,

 

  1. such individual does not include in gross income for such taxable year an item of community income properly includible therein which, in accordance with the rules contained in section 879(a), would be treated as the income of the other spouse,

 

  1. the individual establishes that he or she did not know of, and had no reason to know of, such item of community income, and

 

  1. taking into account all facts and circumstances, it is inequitable to include such item of community income in such individual’s gross income, then, for purposes of this title, such item of community income shall be included in the gross income of the other spouse (and not in the gross income of the individual). Under procedures prescribed by the Secretary, if, taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency (or any portion of either) attributable to any item for which relief is not available under the preceding sentence, the Secretary may relieve such individual of such liability.

 

  • Sale of Principal Residence Real Estate Tax Considerations

 

  • Gain from the sale of real property squarely meets the definition of gross income per IRC § 61(a)(3). The amount of gain realized is determined under § 1001(a) by deducting the basis in the property (The property’s cost plus amounts spent on improvements) form the total amount realized which is generally the proceeds and fair market value of any other property received. Per § 1001(c) the gain realized is recognized unless an exception applies. IRC § 121 provides for an exclusion from the gain required to be recognized of $250,000 for a qualifying individual (or $500,000 for a qualified married couple). Any gain in excess of the exclusion amounts in § 121 is taxed IRC § 1(h) long term capital gain on assets held in excess of one year, which are taxed at either 15% or 20%, depending upon the amount of the taxpayer’s taxable income and filing status.

 

  • Where the taxpayers are divorced, or filing married separate returns while still married, each spouse is required to report his or her allocable share of the capital gain. Where the taxpayers are married and file a married filing joint return, the entire gain will be reported and each spouse will be jointly and severally liable for the total tax shown on the personal tax return.

 

  • IRC Section 121

 

  • Section 121 permits qualifying taxpayers to exclude gain of up to $250,000 ($500,000 for qualifying joint filers) realized on a qualified sale of their principal residence once every two years. Gain is excluded where the taxpayer satisfies the following requirements:

 

 

  • the taxpayer (or, his or her spouse where filing a joint return) has owned and used the home as his or her principal residence (need not be contiguous), for two of the five years immediately prior to the sale; and

 

  • the taxpayer has not utilized § 121 within the two years immediately preceding the current sale.

 

  • Limited exceptions to the ownership, use, and frequency of sale rules for circumstances that are basically beyond the taxpayer’s control are available under § 121(c) but will result in the exclusion being reduced.

 

  • If a couple both satisfy the 2-year use requirements, but only one satisfies the ownership requirement, the couple is never the less eligible for the maximum § 121 $500,000 exclusion of gain. If only one spouse meets the 2 – year use requirements, the couple is only eligible to exclude $250,000 even where both own the property.

 

  • IRC § 121(d)(3) delineates two special rules when separated and or divorced taxpayers sell a principal residence. The first special rule applies where a selling spouse obtained the home from his or her spouse or former spouse in a qualifying § 1041 transaction in which case the selling spouse’s holding period includes the his or her spouse or former spouse’s holding period. The second special rule applies where a spouse or former spouse is granted use of the home under a § 71(b)(2) divorce decree, separation agreement, or spousal support order and used the property as his or her principal residence, in which case the occupancy period granted by the § 71(b)(2) instrument is imputed to the spouse that does not reside in the residence.

 

  • Danger – potential tax trap: A spouse’s individual use of the marital home prior to the execution of a § 71(b)(2) divorce decree, separation agreement, or spousal support order will not be imputed to the nonoccupant spouse for purposes of the above special rules. Thus, both the timing of the sale of the principal residence and the timing of a spouse’s departure from the marital home (separation date) could become strategic where a full $500,000 § 121 exclusion is needed and desired.

 

  • Note; if the primary residence where section 121 is being considered was acquired by “like-kind” exchange via IRC §1031, The §121(a) exclusion will not apply if it occurs during the 5-year period beginning with the date of the acquisition of the property.

 

  • Under 121(b)(4) where a surviving spouse sells within two years after the date of death of his or her spouse and the use and time requirements of § 121(b)(2)(A) were met immediately before the date of death the surviving spouse can claim a $500,000 exclusion.

 

  • Partial § 121 Exclusion are available on “Certain” Sales under 121(c)(2)(B) where the sale is occurring because of qualifying “unforeseen circumstances” that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence that are delineated in Reg. 1.121-3(e).

 

  • Generally, to receive a reduced exclusion, taxpayer must be able to make it clear, in consideration of all the relevant facts and circumstances, the primary reasoning behind the decision to sell was an unexpected a change in place of employment, health or other qualifying unforeseen circumstance.

 

  1. Divorce or legal separation are identified as a qualifying unforeseen circumstance in Reg. § 1.121-3(e)(2).

 

  1. Where a partial § 121 exclusion is available under § 121(c) the amount of gain excludible is prorated using the following formula:

 

The lesser of, the number of

days of qualifying ownership or use,

 × $250,000 / $500,000 (as applicable)
730 days

           

  1. Factors the regulations analyze to determine the taxpayer’s primary reason for the sale include:

 

  1. The timing of the circumstances allegedly causing the sale and the ultimate sale date;

 

  1. If the suitability as a principal residence of the property that was sold was materially altered by unforeseen circumstance;

 

  1. If the taxpayer’s financial ability to maintain the property was materially diminished by the unforeseen circumstance;

 

  1. Whether the taxpayer has actually used the property that was sold as their principal residence;

 

  1. Whether the circumstances that gave rise to the sale were reasonably foreseeable at the properties purchase date;

 

  1. Whether the unforeseen circumstances that the taxpayer claims to have led to the need to sell actually occurred while the taxpayer’s owned and used the property at issue.

 

  1. Where a taxpayer claims the sale was due to a change in place of employment, the services analyzes if the sale was actually motivated by a change in the location of the qualified individual’s employment. The regulations provide a safe harbor where the qualified home owner’s new location of employment is at least 50 miles further from the residence that was sold than the taxpayer’s former place of employment was.

 

  1. Property Used Party for Business Purpose
    1. The regulations under Reg. § 1.121-1(b) adopt a facts and circumstances test to determine if a dwelling qualifies as a taxpayer’s principal residence.

 

  1. Where a residence has been used for both business and personal residence purposes. i.e. where a residential home or portion of it, is rented or used as a home office. IRC § 121(d)(6) provides that any gain that is realized, may not be excluded under IRC § 121 to the extent of post May 6, 1997 depreciation that was claimed.

 

  • Reservation of Jurisdiction

 

  • Where a differed sale of a personal residence is ordered by a divorce court or negotiated between the parties the divorce court will often reserve jurisdiction in order to be able to adjudicate the subsequent sale of the family residence if the event the parties fail to cooperate, agree or a stalemate develops, and where necessary will control the details involving the sale process itself including the allocation and disbursement of sale proceeds, and dictating the tax consequences between the ex-spouses.

 

  • Co – Ownership / Cohabitation Between H and W in the Family Home Post Divorce

 

  • In most divorces the continued joint occupancy of H and W while a sale of the family residence is pending is a nonstarter. Besides most divorcing couple’s inability to continue to live together, other complications quickly develop. Under IRC §§71(b)(1)(C), 215(a)–(b), the parties may not be members of the same household if deductible spousal support payments from the income of the paying party are desired. Also the date of separation, which has tons of ramifications on the divorce discussed elsewhere becomes harder if not impossible to legally identify where the couple continues to live under the same roof.  However, when couples are amiable enough for joint occupancy to be a possibility, this can often reduce the economic burdens caused by having to duplicate living expenses while the divorce is pending and afterward.

 

  • Effect of the “Out Spouse” Paying the Mortgage, Property Taxes, Upkeep on the Family Home Post Divorce

 

  • Shared Responsibility

 

  1. Payments to Third Party on Behalf of Payee & IRC Sec 71

 

  1. In order to evaluate the economic effect of a divorce or separation agreement obligating one party to pay all housing costs, including mortgage payments, taxes and maintenance the tax treatment of these payment must be taken into account. The tax savings may be substantial and can provide some leverage in marital settlement negotiations.

 

  • Three different IRC sections dictate the tax treatment of divorce-related payments of housing costs related to the marital home. The deductibility of home mortgage interest is governed by § 163(h)(3) and § 163(h)(4), the deductibility of property taxes is determined under § 164 and alimony is determined under § 71. Court ordered payments to third parties commonly include payments of mortgage interest and property taxes on behalf of a spouse or former spouse. These expense can potentially be treated as alimony for tax purposes which would give rise to an above-the-line deduction to the payor spouse and escape a potential § 68 overall limitation on itemized deductions if the payments were not considered alimony.

 

  1. If the spouse awarded occupancy of the martial residence co owns an interest in property with the payor spouse, any payments of housing costs qualify as alimony only to the extent of the payee’s ownership interest. Where a home is jointly owned the payor’s payment of housing costs on behalf of the payee qualifies as alimony only to the extent of the payee’s one-half interest.

 

  1. here these expenses do not qualify as an itemized deduction because of § 68, do not result in a benefit because the payor spouse is in AMT and do not qualify as alimony, they will generally constitute nondeductible personal expenses.

 

  1. Under § 71(b)(1), alimony by definition includes qualifying cash payments to third parties on behalf of a spouse where the payments are legally required under a qualified divorce instrument. In order for the payments to be considered made “on behalf of a spouse” the payments to third parties must be made at the written request, consent, or ratification of the payee spouse. The writing must make clear the parties intend that the payments be treated as alimony and executed prior to the date of filing of his federal income tax return which pertains to the payments at issue.

 

  • Payments to third parties that can qualify as alimony include any payments of what constitute legal obligations of the alimony recipient spouse, including rent, tuition, legal liabilities, food, clothing, medical and other living expenses, vacations, education, jewelry and life insurance premiums where the payee spouse is the owner of the policy.

 

  • Taxpayers on occasion have been known to attempt to deduct the payment of their ex spouse’s attorney’s fees as alimony. However, these expenditures will not qualify as alimony unless they meet all the legal requirements for payments to a third party delineated above.

 

  • Deductibility of Legal Fees and Divorce

 

  1. Under Reg. 1.262-1(b)(7) attorney and professional fees paid in securing a divorce, separate maintenance agreement, or decree for child support are generally nondeductible by either spouse.

 

  1. Collection or Production of Income

 

  1. Under IRC sec. 212(1) Fees paid related to securing the production or collection of income are deductible and this is equally true where related to a divorce. Legal fees paid in a divorce to secure a right to receive items of taxable income as part of the marital dissolution and martial property settlement are deductible. For example, legal fees incurred in a legal effort to regain or possess a marital profit seeking business entity are deductible.  Legal fees incurred to secure a right to receive or increase alimony are deductible as Schedule A miscellaneous itemized deductions subject to the 2%-of-AGI limitation.  HOWEVER, legal fees paid in an effort to resist or reduce paying alimony are nondeductible as they are not legally considered related to the production or collection of income.  Along the same lines of logic, since child support payments are not includible in the recipient’s income, legal fees paid to secure child support are nondeductible.

 

  1. Tax Advice

 

  1. Separately stated fees by an attorney, CPA or other tax professional related to the providing of federal, state, local, estate, and property tax advice related to a divorce, separation or spousal support action are arguably related to the production or collection of income are therefore potentially deductible. Where these expenses are deductible, they are 2%-of-AGI miscellaneous itemized deductions, and thus subject to a potential haircut. AMT is also an issue.

 

  1. HOWEVER: a taxpayer is only allowed to deduct legal and professional fees paid for tax advice regarding his or her own taxes. Where the taxpayer was required by a court to pay the legal expenses of his or her spouse, he or she is prohibited from deducting these costs even where they directly relate to tax counsel provided to their ex-spouse.

 

  1. Legal and Professional Fees as an Increase to Basis

 

  1. Where tax advice fees are of no immediate benefit, the tax professional should consider capitalizing the tax advice expenses and adding them ratably to the basis of property a party receives in a martial property settlement agreement.

 

  1. An argument can be made for a taxpayer to add to his or her closely held stock basis the allocable portion of the legal and professional fees they paid in order to retain the ownership their corporation that was at issue during divorce litigation. As a general rule, where legal and professional fees in a divorce relate to assets received via a marital property settlement, the taxpayer is justified in allocating the cost in a prorata fashion among the assets received in the divorce.

 

  1. Billing for Tax Advice, Collection and Production of Income and Defense of Title Services

 

  1. To help a client fully benefit from a tax perspective and determine the proper tax treatment and potential deductibility, or basis increase related to legal and professional fees expended during a divorce, the attorneys and professional should be requested to cull out and specify services related to tax advice, the collection or production of income, or services related to the defense of title to property.

 

  1. Partnership and a Partner’s Divorce Litigation

 

  1. A partnership is prohibited from deducting, and thus the partners will not be allocated a related deduction on their individual K-1s, settlement expenses related to litigation that is brought against an individual partner in that partner’s capacity as an individual.  This legal principle has been applied to deny a partnership a deduction for amounts the partnership paid to ward off financial damage the partnership where a partner’s spouse made demands against a partnership in a divorce action.

 

  • Filing Returns in Divorce Situations
    1. Allocating Tax Carryforwards

 

  1. The final joint tax return before a divorce finalizes will often raise the issue of how carryforward tax items should be allocated between the spouses following a divorce. Specific regulations apply to how some tax carryforward items are to be allocated between the parties in a divorce. Where an allocation method is not specifically required by the regulations a practical method of allocation is warranted.

 

  1. Joint NOLs

 

  • It is very common for marital settlement agreements negotiated between the parties through divorce attorneys to dictate how joint NOLs incurred over the marriage are to be allocated between the spouses upon dissolution. Many family law attorneys would be surprised to learn that the agreed apportionment of the couple’s NOLs negotiated between the parties will not be respected by the federal courts or the IRS should it come to light. There is no provision in the IRC that allows the allocation of NOLs between the parties either by contract or by state court decree. The proper allocation of NOL’s between the parties that would be respected by the federal courts and the IRS is found under Regulation 1.172-7(d)and in IRS Publication 536.

 

  • The party that gets to benefit from a carryforward NOL flowing forward from a joint return to one of the party’s separate tax return following a divorce depends on which party generated the NOL. If the NOL was generated by one of the spouses separately, the carryover is allocated to the spouse that generated it. If both H and W generated the NOL, Under Reg. 1.172-7(d) the NOL carryforward is required to be apportioned between the spouses in the same manner as if each spouse’s separate NOL carryforwards would have been calculated had each spouse filed married filing separate returns in the tax years that generated the NOL.

 

Consider the Following Example:

 

  • Bob and Samantha filed joint returns for 2013 and 2014. They sustained a joint NOL of $2,000 for 2013 and a joint NOL of $4,000 for 2014. For 2014, Bob’s total business deductions exceeded his gross business income by $1500, and Samantha’s business deductions exceeded her gross income by $500. Therefore, $1500 of the $2,000 joint NOL for 2013 is considered to be Bob’s and $500 is considered to be Samantha’s. For 2014, Bob’s gross business income exceeded his business deductions by $2,500, and Samantha’s business deductions exceeded her gross business income by $1,500 Therefore, $2,500 of the $4,000 2015 joint NOL is considered to be Bob’s separate NOL and $1500 is considered to be Samantha’s.

 

  1. Minimum Tax and General Business Credit Carryforwards

 

  • There is currently no official published authority on how to go about allocating a minimum tax credit (MTC) carryforward between the parties to a divorce that were accumulated on married filing joint income tax returns before dissolution. The recommend approach per Ltr. Rul. 8828032, is to allocate MTC carryforwards is with reference to the properties or businesses that created the timing differences and allocating the MTC in the ratio that each property or business created the total timing difference. Once each property or business that created the MTC receives an allocation of the total MTC the parties would get to benefit by the MTC that follows the property or business each spouse is awarded in the marital property settlement agreement or order.

 

  1. Investment Interest Expense Carryforward

 

  • At present, no primary authority or judicial precedent exists that provides guidance as to how invest interest carryforwards are to be allocated among divorcing spouses. It seems reasonable then that investment interest carryforwards can be allocated in any reasonable manner including based on the property and activity that generated the expenses as long as the allocation is consistent for both regular tax and AMT purposes.

 

  • Capital Loss Carryforwards

 

  • Under Reg. 1.1212-1(c)(1)(iv), Capital loss carryforwards are required to be allocated by analyzing each spouse’s separate capital losses that gave rise to the carryforward. Where the properties that generated the capital losses ae jointly owned, or the equivalent in a community property state, any loss carryforwards are equally split between the divorcing spouses.

 

  1. Charitable Contribution Carryforwards
    • Under Reg. 1.170A-10(d)(4)(i)(b), any charitable contribution carryforwards that were generated on married filing joint returns are apportioned between the divorcing spouses in the ratio that would have resulted had if the spouses had filed married separate returns for the year the excess charitable contributions arose. A problem with this requirement is once the two spouses file “married filing separately” many of the tax rules change and so do the resulting charitable loss carryforwards when separately stated.

 

  • Legal Authority to Seal Court Records

 

  1. The need to seal sensitive financial records in a family law court file is an issue that occasionally arises as a result of the divorce discovery process. The current ability of divorcing parties to obtain a court order to seal their financial records has become increasingly more difficult following a 2006 appellate court holding in Marriage of Burkle (2006) 135 CA4th 1045, 1063 that declared California’s family law sealing statute found under Fam C §2024.6, as unconstitutional.

 

  1. In Burke, the Los Angeles Times and the Associated Press filed suit to oppose the litigant’s ex parte request to seal his financial documents, citing as grounds for the position the public’s right to know and a presumed right of access to records in divorce cases.

 

  • The trial court found and the appeals court upheld a finding that that Fam C §2024.6 was unconstitutional as violate of the First Amendment as the section was “not narrowly tailored to serve the privacy interests it is intended to protect, and less restrictive means of protecting the privacy interests are available.”

 

  1. The Statutory authority declared unconstitutional is found in Fam C §2024.6. which provided for the sealing of financial information delineating the assets and debts in a particular family law case. This section provided a means for any party to a family law case to simply make an ex parte request, without the need for a hearing, in order to seal any court pleading that lists the party’s financial assets and liabilities.

 

  1. Redaction Under Fam C §2024.5

 

  • There is an alternative to sealing sensitive financial information that leads to more limited relief, under Fam C §2024.5(a). This section allows for the redaction of “any social security number from any pleading, attachment, document, or other written material filed with the court pursuant to a petition for dissolution of marriage, nullity of marriage, or legal separation in order to protect social security numbers from being stolen or used for identity theft.