Getting divorced is tough. Two lives joined together are split asunder and the last thing on anyone’s mind is taxes. However, understanding the impact of taxes on a property division is key to making sure a division of property is truly equitable. Hidden taxes in the property divided can further aggravate what might already not be an equal division of the marital estate. The reason for this potential disparity is simple: IRC § 1041.
The Rules:
IRC § 1041 governs the tax treatment of transfers between spouses and divorcing spouses. It applies to a gift, sale, exchange or other transfer. Congress believed that whether during marriage or through divorce the transfer of property between spouses should not result in either a gain or loss. While no gain or loss is recognized on the transfer, the recipient spouse obtains a basis in the property equal to what it had in the hands of the transferor. Homes, stocks, bonds, mutual funds and business assets fall under the category of property where the fair market value is normally different than the basis. Generally speaking the property’s basis is the purchase price.
IRC § 1041 is automatic so there’s no way to elect out of the tax-free treatment if the transfers fall under IRC § 1041’s umbrella. Even if the spouses intend for a transfer to qualify as a sale, no gain or loss is recognized. IRC § 1041 applies to either any transfer made within one year of the divorce or to transfers made within six years of the divorce becoming final if made pursuant to a divorce judgment or separation agreement. Transfers made within one year after the divorce becoming final are presumed to be covered under IRC § 1041, even if the transfers are not covered in any divorce judgment or separation agreement. Transfers made within six years after the divorce are final only fall under IRC § 1041 if the transfers are made pursuant to a divorce judgment or settlement agreement. Both of these types of transfers cover a wide variety of transfers between divorcing spouses. There are exceptions to this general rule (isn’t there always!) but these exceptions do not normally apply in most divorces, such as transfers to non-resident alien spouses or transfers to a trust on behalf of the other spouse.
The Problem:
While on the surface this tax treatment sounds pretty good – who wants to pay taxes on a transfer between soon to be ex-spouses. The problem is that there are hidden tax consequences that lay dormant until the transferred property is later sold, transferred or otherwise disposed. IRC § 1041 provides that the basis of the property exchanged remains the same in the hands of the recipient spouse as it does in the hand of the tranferor spouse. Because no gain or loss is recognized there is no step up in basis to fair market value. It is this little provision that creates the tax trap. No one who is getting divorced is really thinking about this issue and so what might appear to be a fair settlement based on the current market values of the property may be less than what was bargained for due to taxes. Investments, retirement accounts and property that has been depreciated (like a rental property) are the things that normally come to my mind.
Here’s a simple example to highlight the problem:
Ted and Martha own between them two pieces of property, stocks worth $50,000 (with a tax basis of $25,000) and cash totaling $50,000. Martha wants to move away and so she wants the $50,000 in cash. Ted is fine with this arrangement as he wants to keep the stock so he can hopefully sell it later for more than $50,000.
On the surface this appears to be a fair division of the property. Both are walking away with 50% of the marital estate. Only later when Ted decides to sell the stock does the problem arise. Ted is going to recognize at least a $25,000 gain upon the sale, assuming that the stocks increase in value. Ted’s basis in the stock is $25,000 not $50,000. So he is going to have to pay taxes on the gain embedded in the stock he received. Martha on the other hand has cash, which has a basis equal to its face value – so $50,000. Martha’s $50,000 was tax free while Ted’s stock was not. Ted gets something less than $50,000 for his share of the marital property.
While this is a simple example, imagine if both Ted and Martha had a bunch of stocks, mutual funds, company retirement and a business in the mix. Things can get complicated very quickly, which is why careful consideration of the problem is needed.
Summary
In summary, it’s important understand the tax rules regarding transfers between divorcing spouses. Dividing up the marital estate is not simply a matter of valuing the property and then parceling it out. Care has to be taken regarding potential taxes that may crop up when the property is later transferred, sold or otherwise disposed of. By taking into account the taxes due on a later sale it may be possible fashion a more equitable division in the divorce judgment or separation agreement.
If you have any questions or concerns about what I’ve written please feel free to contact me by phone at 207 – 299 – 0515 or by emailing me using my contact form.