(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.)
Recapture of Depreciation
In general, there is no recapture of depreciation on Section 1041 transfers.
1.Transfers between spouses are treated as gifts.
a) Property transferred by gift does not require recapture at the time of the gift.
(b)Recipient spouse is responsible for recapture, if and when property is sold at a gain.
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:
Original purchase price of machines
3 x $2,500 = $7,500
Depreciation allowed = <$7,500>
Adjusted Basis -0-
Sales Price 3 x $500 = $1,500
Depreciation recapture recognized as ordinary income
$1,500 – 0 = $1,500
(c)Recapture of Section 179 depreciation.
IRC Section 179 allows for the immediate expensing of qualified personal property used in a trade or business. If such property is taken out of service before the end of its recovery period, the associated Section 179 deduction taken on such property must be recaptured as ordinary income. Recapture in these circumstances is immediate, however, it is only required to the extent the Section 179 deduction exceeds the amount of otherwise allowable depreciation. A similar recapture provision exists for Listed property when Bonus Depreciation has been applied.
Example of Section 179 Depreciation Recapture:
Assume the same facts as in the previous example except that the three (3) frozen yogurt machines were fully depreciated in the year they were placed in service via a Section 179 election. Also assume that the machines are awarded to Ethel as part of a global property settlement, and Ethel decides to close the yogurt business. She then places two (2) of the machines in storage and installs the third one in her home kitchen for her personal use. This occurs at the beginning of what would have been year four (4) of the machines’ useful life using MARCS straight line with a 5-year life.
Under MARCS at the end of three (3) years the machines would have been depreciated as follows:
|Year 1||$ 750||½ yr. convection|
|Year 4||$ 750||½ yr. convection|
Ethel, therefore must recognize $3,000 of Section 179 recapture as ordinary
Income calculated as follows:
Section 179 deduction previously allowed: $7,500
Less MARCS depreciation allowable during the time machines were in service <$4,500>
Net Recapture $3,000
B. Assignment of Income Issues
The central question of the Assignment of Income Doctrine in divorce cases is the matter of what is viewed as “Property”, as opposed to “Income”
1.Assignment of Income doctrine general rule. The Assignment of Income Doctrine states that in general, income is taxed to the person or entity who earns it.
Example: Ozzie and Harriet finalize their divorce on December 5, 2021. As part of the global settlement, Ozzie agrees to give Harriett 33% of his net salary for ten (10) years into the future. Ozzie will still be responsible for reporting and paying tax on his entire salary.
2.Revenue Ruling 2002-22.
Revenue Ruling 2002-22 is frequently used as an example of how the Assignment of Income Doctrine interacts with IRC Section 1041. The ruling states that VESTED employer stock options and deferred compensation that are transferred incident to a divorce are taxed to the transferee spouse when such income is ultimately received by the transferee spouse. Hence the IRS has taken the position that taxing the transferor spouse, (when in fact it is the transferee spouse who ultimately receives the income), would impede the congressional intent of IRC Section 1041.
Tax Trap Alert: It is important to note that Revenue Ruling 2002-22 only applies to nonqualified stock options and deferred compensation rights that are vested or no longer subject to substantial contingencies, and transferred in the context of a divorce. Outside of the above, the position of the IRS is that the employee spouse is responsible for the Federal Income Tax liability, even if it is the non-employee spouse who exercises the option or receives the deferred compensation.
Tax Practitioners And Taxpayers Welcome To Contact David With Questions.
Have a question? Contact David Ellis, Ellis & Ellis CPAs.
 Section 1245(a), Reg.1.179-1(e)(3)
Section 179(d)(10), Section 280(F)(2)
Lucas v. Earl, 1930 281 US 11c
(Next Post in Series, Part 11 Will Discuss Transfers of Closely Held Businesses)
(This material is for informational purposes only and is not a substitute for tax advice from a qualified professional and the author assumes no liability whatsoever in connection with its use. No advisor/client relationship exists.)
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