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Transfers of Assets in a Divorce Pt I of III
November 10, 2009
With almost half of all marriages ending in divorce, it may benefit many of our readers to learn about some basic tax and accounting issues affecting the divorcing couple. This will be the first in a three part series on tax and accounting incident to divorce. Our litigation and forensic accounting division works closely with divorcing couples and their attorneys to try and structure settlements to minimize the (sometimes unexpected) tax impacts related to the splitting of their assets. The first section is dealing with the tax free transfer of assets under the current tax law.
Section 1041 was added to the Internal Revenue Code by section 421 of the Tax Reform Act of 1984 (1984 Act), Public Law 98-369. Section 1041(a) provides that no gain or loss will be recognized on a transfer of property from an individual to (or in trust for the benefit of) a spouse or former spouse if the transfer is incident to a divorce. Under section 1041(b), for purposes of subtitle A, the transferee is treated as having acquired the property by gift from the transferor with a carryover basis from the transferor.
§1041 applies to assets that are owned by the divorcing couple. Common examples include personal and vacation residences, automobiles and stocks. In general, the transfer of the asset(s) must occur within one year after the date on which the marriage ceases or must be related to the cessation of marriage. The IRS will generally treat a transfer of property up to six years after the divorce is finalized as a qualifying transfer, as long as it can be shown that it was related to the divorce. This can be an important time frame to utilize. Some of the credits and carryforwards that are included in tax returns can be lost when transferring them among spouses. However, if an agreement can be worked out where a transfer can occur years down the road, after the credits or losses have been fully utilized, a better tax result can be achieved.
One additional item to note is that §1041 is not optional, it is mandatory. If a couple is divorced in December 2008 and the taxpayer elects in May 2009 to give his ex-wife IBM Stock worth $30,000 (his original purchase price was $20,000) in order to forgo the remaining $30,000 of spousal support, the following is the result:
- The taxpayer cannot take a deduction for alimony for the $30,000, as the payment was not cash.
- The taxpayer does not have to pick up a $10,000 taxable gain on the sale of stock.
- The ex-wife does not have to pick up any of the $30,000 as alimony, as it is a non taxable transfer of stock.
- The ex-wife now has a carryover basis of $20,000 and would pay capital gains taxes on $10,000 if she sold it that day.
Transfers to third parties
A transfer can also be made to a third party on behalf of a (former) spouse, and the transaction can be treated as nontaxable. One of the following must occur in order for this to take place:
- The transfer is required by divorce/separation decree
- The transfer is pursuant to a written request of spouse
- The transfer is consented by the receiving spouse in writing and attached to the transferring spouse's tax return stating that they want §1041 to apply
Most residence sales would qualify as tax free even without §1041. However, the sale of assets directly to third parties can be beneficial when applied to other marital assets, especially if the two parties are in substantially different tax brackets in the year of divorce.
1041 Planning Example
Fact Pattern
- Tom and Jane are divorcing
- Tom is in the 40% combined federal and state tax bracket (20% combined for Capital Gains)
- Jane is in the 25% combined tax bracket (15% for Capital Gains)
- Tom has agreed to pay $15,000 to Jane's attorney as a part of the divorce settlement.
- Tom is planning on using stock that is worth $15,000 with a tax basis of $5,000 (potential gain of $10,000)
- What is the best way for Tom to get the $15,000 to Jane's attorney?
Option 1 - Sell the stock and transfer the money to Jane as an additional property settlement.
- Tom's cost = $15,000 + Taxes of $2,000 ($10,000 gain x 20%) = $17,000
Option 2 - Transfer the stock to Jane under section 1041 and pay her taxes on the sale.
- Tom's cost = $15,000 + Jane's Taxes of $1,500 ($10,000 gain x 15%) = $16,500
Option 3 - Tom sells the stock and transfers the cash to Jane as spousal support (payments terminate upon Jane's death). Tom agrees to pay Jane's income tax impact from the support as additional support.
- Tom would still owe $2,000 capital gain on his sale of the stock and would owe Jane $15,000 + $5,000 for taxes on the combined support ($20,000 x 25% = $5,000).
- Tom gets a tax deduction for the $20,000 paid to Jane. Therefore, the transaction only costs Tom $14,000 ($20,000 + $2,000 - $8,000 tax savings).
- by: Richard L. Craig, CPA/ABV/CFF, CVA, CITP
