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Archive for Dividing Property In A Divorce Tax Traps

Dividing Property In Divorce Tax Traps – Part 13 In Series

Dividing Property In Divorce Tax Traps – Part 13

1. Taking Basis into Consideration When Dividing Property

Even though IRC Section 1041 generally allows for the tax-free transfer of property between spouses in a divorce, the basis of such property relative to its current (or projected) Fair Market Value is critical in determining an equitable division of the marital estate.

Example:  Fred and Ethel are engaged in divorce proceedings. The primary asset in the marital estate is a rental apartment building that they have owned for thirty years as community property.  The basis of the property is $200,000 and the fair market value of the building has been appraised at $800,000.

Sales Price of Land   $800,000
Less Fred’s Original Basis <$100,000>
Less Fred’s Additional Basis Transferred from Lucy <$100,000>
Net Gain    $600,000
Tax on Gain (assuming a combined Federal and State rate of 30%) $180,000
Fred’s Net After Tax Gain $420,000

Assume that it is agreed that Fred is to buy out Ethel’s 50% interest in the building for $400,000.  Such a transaction would be covered under the general provisions of IRC Section 1041 and would be tax-free to Ethel, with Fred assuming Ethel’s share of the building’s carryover basis.  Were Fred to sell the building he would likely have the following economic and tax consequences:

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Dividing Property In Divorce Tax Traps – Part 12 In Series

DAVID ELLIS _ Divorce And Dividing Property

(Part 12 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)

D. Dividing Interest in S Corporations and Other Pass-Through Entities

A large percentage of closely held businesses are organized as “pass-through entities”.  This means that the income, loss, special deductions, and the like are reported on the individual tax return of the entities’ owner rather than the businesses themselves.  Common forms of pass-through entities that need to be allocated between spouses in a divorce situation include S Corporations, LLCs, and Partnerships.  Trust and estates, typically being separate property bequest, would not generally be expected to cause separate property issues.

The division of interest in pass-through entities, is subject to the general rules of IRC Section 1041 (nonrecognition of gain/loss, carryover of basis, etc.).  However, ownership of pass-through entities—especially in the form of a closely held business, can be a double edge sword.  Issues that should be taken into consideration, include but are not necessarily limited to the following:

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Dividing Property In Divorce Tax Traps – Part 11 In Series

DAVID ELLIS _ Dividing Property In Divorce

(Part 11 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)

C.Transfers of Closely Held Businesses

In a divorce, it is often the case that the family business will be one of the most valuable assets in the marital community.  Generally, the transfer of the stock in a closely held business will enjoy the protection of Section 1041 in the context of divorce.  Likewise, the basis and holding period will carry over to the transferee spouse, thereby deferring the recognition of any gain or loss to him/her.[1] However, the transfer of closely held stock can be accomplished through various means, under a variety of circumstances, with the resulting tax burden born in some cases by the transferor spouse, and at other times by the transferee spouse.

1. Cash Buyout

The simplest scenario in a divorce related transfer of a closely held business would be a cash buy out of one spouse by the other.

Example: Barney and Betty are in the process of divorcing.  They own 100% of the stock in a granite quarry that they acquired during the marriage.  The stock has an appraised value of $500,000.  As part of the divorce agreement it is decided that Barney will buy out Betty’s interest for $250,000.  The basis of the shares in total is $50,000.  Barney proceeds to buy out Betty’s interest for $250,000.  In accordance with IRC Section 1041, no gain or loss is recognized on the transfer.  Barney’s basis in the stock is increased from $25,000 to $50,000.

2.Stock Redemptions for the Family Business

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Dividing Property In Divorce Tax Traps – Part 10 In Series

Dividing Property In Divorce Tax Traps – Part 10

(Part 10 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)

Miscellaneous Issues

Recapture of Depreciation

In general, there is no recapture of depreciation on Section 1041 transfers.

1.Transfers between spouses are treated as gifts.[1]

a) Property transferred by gift does not require recapture at the time of the gift.[2]

(b)Recipient spouse is responsible for recapture, if and when property is sold at a gain.

Example:

Fred and Ethel are divorcing. They own a retail frozen yogurt shop as community property.  As part of the global property settlement the business and related equipment is divided. There are three (3) machines used for making the frozen yogurt—each one has an original purchase price of $2,500.  Each machine has been fully depreciated using MARCS 5-year straight line.  Several years after the divorce is final, Ethel sells each machine at a local flea market for $500.  Ethel will recognize $1,500 in Section 12 45 recapture, calculated as follows:

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Dividing Property In A Divorce Tax Traps – Part 1 In Series

David Elllis CPAs - Tax Aspects Of Dividing Property In A Divorce

This valuable series on Dividing Property In A Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.

Dividing property during divorce may be one of the most difficult issues faced by tax planners. While most professionals are familiar with the general rule that property transferred during marriage and/or divorce proceedings is usually tax free [1], they may be less aware of the many thorny tax pitfalls that await the unwary. As with most tax matters, “the devil is in the details”. Issues such as how property is held, basis, depreciation, tax credit recapture, and holding period, are but a few of the problems that will confront tax practitioners in a divorce engagement.

Sometimes the tax impact of decisions made during divorce proceedings will not be realized, much less recognized, until many years down the road. Other times, the tax consequences may be just around the corner. The purpose of this course is to arm practitioners with the knowledge that will help them see what is coming down that road, or around that corner… while there is still time to do something about it.

I. The Big Rule – Code Section 1041 Overview 

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