Source: https://www.walzermelcher.com/practice-areas/tax-issues-when-dividing-property-incident-to-divorce/
Timestamp: 2019-04-18 17:20:57+00:00

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Although most transfers between spouses or former spouses in the context of a marital dissolution will be non-taxable, there are some important exceptions. For example, this rule does not apply when the recipient spouse is a non-resident alien. Transfers between former spouses which occur more than six years from the date of the divorce will be taxable unless the taxpayer shows that they are incident to the divorce. And, a person cannot avoid paying taxes on a vested right to income by assigning the right to receive that income to his or her spouse. These exceptions are discussed below. The importance of obtaining records showing the tax basis in the asset received through divorce is also highlighted.
Internal Revenue Code section 1041 provides that a transfer between spouses, or former spouses, “incident to divorce” is not taxable in most circumstances. The transfer is treated like a gift. The transferee takes the transferor’s tax basis in the property. The effect of the rule is to defer the tax consequences (recognition of gain or loss) until the transferee disposes of the property. Sec. 1041. Transfers of property between spouses or incident to divorce. (a) General rule.
(2) is related to the cessation of the marriage. (d) Special rule where spouse is nonresident alien. Subsection (a) shall not apply if the spouse of the individual making the transfer is a nonresident alien.
(2) the total of the adjusted basis of the property transferred. Proper adjustment shall be made under subsection (b) in the basis of the transferee in such property to take into account gain recognized by reason of the preceding sentence.
“For example, the presumption may be rebutted by showing that (a) the transfer was not made within the one-and six-year periods described above because of factors which hampered an earlier transfer of the property, such as legal or business impediments to transfer or disputes concerning the value of the property owned at the time of the cessation of the marriage, and (b) the transfer is effected promptly after the impediment to transfer is removed.” (Id.) In Private Letter Ruling 9235026 (May 29, 1992), the IRS ruled that the six-year presumption was overcome when the transfer of the Wife’s interest in business property to her ex-husband was incident to divorce even though the transfer occurred more than six years after the divorce. The IRS found that the transfer was delayed because of a dispute over the purchase price and payments terms, and that the transfer was effected promptly after the dispute was resolved. The IRS noted that Temp. Treas. Reg. §1.1041-1T, A-7 specifically provides that the presumption may be rebutted if factors such as “disputes concerning the value of the property” to be transferred prevented an earlier transfer.
When the spouse who receives property incident to divorce is a nonresident alien, taxable gain will be recognized on the transfer. (IRC §1041, subd. (d).) The spouse making the transferor will be taxed on the gain (the difference between the fair market value of the property transferred and his or her adjusted tax basis in the property). The rationale for treating nonresident aliens differently is that the IRS assumes that it will eventually receive taxes on any gain realized when a spouse who receives property incident to divorce sells the property, since the spouse takes the transferor’s basis in the property; however, in the case of a nonresident alien, there may be little chance that the gain is ever reported or that tax will be paid.
Income is ordinarily taxed to the person who earns it; one vested with the right to receive income cannot escape taxes by an assignment of the right to receive that income to another. (Lucas v. Earl (1930) 281 U.S. 111 (1930); Harrison v. Schaffner, 312 U.S. 579, 580; IRS Regulations, § 1.454-1(a).) Under the assignment of income doctrine, the transferor remains obligated to pay taxes on the accrued income he or she has assigned.
The assignment of income doctrine applies when the right to receive the income has already accrued, and the parties assign that right to the spouse who did not earn the income. For example, in a transfer of Series E or EE United States Savings Bonds to a spouse or former spouse, the transferor must include the accrued interest on the bonds in his or her gross income in the year of the transfer. (Rev. Rul. 87-112.) IRC § 1041 cannot be used to avoid recognition of the gain by transferring the right to receive the income already earned. However, when an income-producing asset is transferred, the right to receive future income is transferred along with the underlying asset, such that the spouse receiving the asset is responsible for paying taxes on that income. For example, if a spouse is awarded an apartment building in a divorce, the spouse receiving the building will not recognize any gain on the transfer and will be responsible for reporting the rental income on his or her tax return. On the other hand, if the parties make an agreement that one spouse will be solely responsible for paying taxes on the past rental income from the building (when it was held as marital property), the assignment of income doctrine will override that contractual allocation and require both parties to report the taxes.
Another example is where Wife agrees to pay Husband 40% of her bonus income as taxable spousal support. When Wife receives the bonus, she will have to report 100% of it as taxable wages, however she gets a deduction for the portion she pays to Husband as alimony. Revenue Ruling 2002-22 held that a taxpayer who transfers interests in nonstatutory stock options and nonqualified deferred compensation to the taxpayer’s former spouse incident to divorce is not required to include an amount in gross income upon the transfer. The ruling also concludes that the former spouse, rather than the taxpayer, is required to include an amount in gross income when the former spouse exercises the stock options or when the deferred compensation is paid or made available to the former spouse.
The court in Armacost held:Interest on indebtedness must be allocated in the same manner as its underlying debt. [Citation.] Underlying debt is allocated by tracing specific disbursements of the proceeds to specific expenditures. If the underlying debt is incurred as a personal expenditure, the interest on that debt may not be deducted under section 163 except to the extent such interest is qualified residence interest. [Citations.] But if the underlying debt is incurred to acquire investment property, the interest on that debt is deductible under section 163 as investment interest. [Int.Rev. Code §163 (h)(2)(B).] Investment interest is defined as any interest paid on indebtedness properly allocable to investment property. Section 163(d).
Investment property includes property producing gross income from interest, dividends, annuities or royalties not derived in the taxpayer’s trade or business, or property held in the course of the taxpayer’s trade or business which is neither a passive activity nor an activity in which the taxpayer materially participates. Section 163(d)(5)(A), 469(e)(1).
Section 1041 applies only to taxes under federal law. The transfer could still be taxable under state law.
Community property laws require the court to divide the community estate “equally” unless required otherwise by law or absent the written agreement of the parties. (See, e.g., Cal. Fam. Code, § 2550.) If tax consequences are not considered when dividing assets, the ultimate division is often far from being equal.
It is the attorney’s role to investigate the tax implications of the proposed division and to advise the client accordingly. In particular, the difference between the fair market value of an asset and its tax basis must be taken into account when evaluating whether there is an “equal” division of the marital estate. In negotiating settlements, the parties are free to discount property based on built-in tax liability associated with an asset.
Family courts at least in California, on the other hand, have been reluctant to take tax effects into account except when it is clear that the party will suffer immediate tax consequences from an expected sale of the property or from the transfer itself. An often-cited case in this area is In re Marriage of Fonstein (1976) 17 Cal.3d 738 where the California Supreme Court held : “Regardless of the certainty that the tax liability will be incurred if in the future an asset is sold, liquidated or otherwise reduced to cash, the trial court is not required to speculate on or consider such tax consequences in the absence of proof that a taxable event has occurred during the marriage or will occur in connection with the division of the community property.” (Id. at p. 749, fn. 5.) In Fonstein, the trial court assigned husband’s minority interest in a law partnership to him in a marital dissolution action after discounting its value for future tax consequences when sold. Under the partnership agreement, the husband had the right to withdraw from the partnership voluntarily and would receive a sum of money based on a formula set forth in the agreement. Although the husband had no intention of withdrawing from the partnership, the trial court discounted the value of the partnership interest by the taxes he would have to pay if he later decided to withdraw.
If a residence is transferred to a taxpayer incident to a dissolution of marriage, the time the taxpayer’s spouse or former spouse owned the residence is added to the taxpayer’s period of ownership.
The exclusion can only be applied to one residence every two years, excluding pre-May 7, 1997 sales.
The judgment should specifically require the exchange of this information.
The right to deduct losses associated with an asset may be transferred together with the asset which generated the loss, or may be personal to the taxpayer and not subject to transfer, depending on the type of asset transferred. This is a complicated area because the loss carryforward was typically reported on a joint tax return during marriage and then, after the divorce, it may have to allocated between the parties for their separate returns. Still, the effort may be worthwhile due to the value of these carryforwards.
When the stock in such a corporation is owned as community property and transferred or divided incident to divorce, the suspended loss carryforwards associated with the stock are transferred along with the stock on a pro rata basis based on the number of shares owned by each spouse during the tax year. (See IRC § 1367.) In an inkind division of the stock which was equally owned by the parties during marriage, each spouse will receive one-half of the suspended loss carryforward.

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