I’ve written before about the emotional roller coaster that can come along when it’s time to divide assets during the divorce process. Today my colleague Jen Green offers the first of several tax rules – and their consequences – for transferring certain property between former spouses. Stay tuned next week for her assessment of additional tax rules in Part 2.
Dividing the marital property pursuant to a divorce can be quite stressful. Nevertheless, it is important to understand the tax ramifications when distributing property between the former spouses. Although most transfers of marital property between former spouses are generally non-taxable, there are some important tax issues that should be understood at the outset in order to avoid any unexpected tax consequences.
To begin with, one must be cognizant of the tax basis in the property received by the former spouse. Knowing one’s tax basis affects the amount of gain or loss that will be required to be reported when the property received is eventually sold. In addition, some transferred property, such as the principal home, qualifies for gain exclusion up to a certain threshold amount when the residence is sold. The transfer of other assets, such as certain business interests, may or may not trigger tax consequences upon its distribution to the other spouse. Other types of property, however, such as assigning one’s income to the other spouse, cannot avoid income tax recognition despite its transfer to the other spouse pursuant to a divorce. The transfer of various assets between the former spouses requires a more detailed understanding of how the tax rules come into play. Below is a brief discussion regarding the tax rules and consequences for transferring certain property between former spouses.
1. General Rule
A transfer between spouses that is “incident to divorce” is not taxable in most circumstances. The recipient spouse carries over the tax basis in the property. The effect of the rule is to defer the tax consequences (recognition of gain or loss) until the recipient spouse disposes of the property. For example, pursuant to a divorce, the marital property is divided up such that Wife, the recipient spouse, receives a painting that was purchased by Husband, former spouse, at $100. There will be no tax consequences to Wife upon receiving the painting. Wife will continue to have a tax basis of $100 in the painting. When 5 years later, Wife sells the painting for $1,000, she will recognize $900 of gain ($1,000 purchase price minus $100 tax basis).
2. “Incident to Divorce“
A transfer of property is “incident to the divorce” if the transfer (1) occurs within one year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage. A transfer is “related to” the cessation of the marriage when the transfer is required under the divorce or separation instrument, and the transfer takes place within six years from the date of the divorce. If the transfer is not made pursuant to a divorce or separation instrument, or occurs more than six years after cessation of the marriage, it is presumed to be unrelated to cessation of the marriage. The presumption, however, may be rebutted by showing that the transfer was made to effect the division of property owned by the former spouses at the time their marriage ceased.
3. Tax Basis and Holding Period
It is extremely important to maintain adequate records about the transferred property’s basis and holding period of such property. This is critical in determining the amount of gain or loss recognition and the characteristic of the gain or loss (long term, short term, or ordinary income). The divorce agreement should specifically require the exchange of basis and holding information when transferring property between the former spouses.
In Part 2, I will cover tax rules 4-6 (principal residence, business interests and assignment of income doctrine). Stay tuned!