Generally, under Internal Revenue Code §1041and Treasury Regulations §1.1041-1T transfers of property between spouses (or to a trust for the benefit of a spouse) during marriage and between former spouses incident to divorce are tax free for income tax purposes. The transaction is treated as a gift and the transferor's tax basis carries over to the recipient. Equal division of community property is also tax free, and this may avoid some restrictions of section 1041.
Here are some of the issues that can arise:
Gift Taxes. Is the transfer also gift-tax free? Transfers during marriage are generally exempt from gift tax ( but not for noncitizen spouses). Depending on when a marital settlement agreement is entered into Internal Revenue Code §2516 may make a transfer after divorce gift-tax-free. In certain circumstances a court order may make a post-divorce transfer gift-tax-free. Also, if you can show that the transfer was made "for full and adequate consideration in money or money's worth" the transfer will be gift-tax-free; but only certain kinds of consideration will qualify. Note that transfers to children - even as part of an agreement to settle marital issues -- may have significant gift tax problems.
Transfers Long After the Divorce. Transfers within a year of divorce are treated as incident to divorce, and so are transfers within 6 years of divorce if they are pursuant to a "divorce or separation instrument." But what of later transfers? Don Read obtained an IRS private ruling for a client on a transfer nearly 20 years after the divorce, but transfers more than 6 years after divorce are presumed to be taxable.
Sales. The basis carryover rule applies even if a section 1041-type transfer otherwise seems like a bona fide sale. For example, suppose one spouse "buys out" the other spouse's interest in the marital home (that has substantially appreciated in value) for cash. The purchaser does not get a "stepped-up" basis to the cash price paid; so the purchaser may be taxed on an excessive amount of gain - gain actually enjoyed by his or her former spouse, who paid no tax -- when the property is later sold. Care must be taken in planning around this (for example, when the former spouse wouldn't have been taxed anyway because of the $250,000 exclusion on sales of residences)
Nonresident Aliens. §1041 does not apply when the recipient is a nonresident alien for tax purposes. Equal division of community property involving a non-resident alien may still be tax-free.
Transfers Involving Third Parties. Transfers to a third party "on behalf of" a spouse or former spouse can qualify under section 1041. Determining whether a transfer to a third party is "on behalf of" the other spouse may be difficult. For example, Treasury Regulation §1.1041-2 was required to settle the rules for determining whether a jointly-owned corporation's buying back one spouse's stock should be treated as a stock redemption between that spouse and the corporation or as a dividend distribution to the other spouse followed by a tax-free §1041 transfer between the spouses.
Partnership Interests. Where the spouses own partnership interests, a tax-free transfer of one spouse's interest to the other may terminate the partnership (if they were the only partners) or reduce one spouse's share of partnership liabilities, possibly causing unexpected tax consequences. Watch out for possible suspended passive losses, the benefits of which may be severely postponed.
Net Operating Losses and Other Tax Attributes. Do not assume that net operating loss carryovers, capital loss carryovers, charitable deduction carryovers and other tax attributes can be freely assigned between divorcing spouses.
Special Assets. Qualified retirement plan benefits can only be transferred by qualified domestic relations orders (QDRO's). Nonqualified deferred compensation benefits should be transferred by domestic relations orders (DRO's). IRA's must be transferred by IRC section 408(d)(6)/71(b)(2)(A) instruments. See other tabs for discussion of these assets.
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