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:

Note that because there is a carryover of basis in IRC Section 1041 transfers,[1] Fred’s basis in Ethel’s one half of the property is only $100,000 ($200,000 original basis divided by 2), NOT the $400,000 that he actually paid in cash to Ethel for her half of the Fair Market Value of the property.  So, in terms of the economic reality of what has happened—Fred has paid Ethel’s share of the tax on the gain on the appreciation of the property totaling $90,000 ($180,000/2 = $90,000).

The results may be even more disparate when factors such as depreciation recapture and the difference in tax rates between the parties are taken into consideration.  Family courts have varying views on the tax consequences of dividing property as discussed below, but in the final analysis, it is generally the case that taking tax basis into consideration is important when dividing the assets of the marital estate.

Tax Trap Alert: Courts Differ

Although the divorcing parties are free to take the difference between the fair market value of an asset and its tax basis into account when negotiating a property settlement, family law courts are not necessarily so obliged.  For example, courts in California will generally hesitate to consider tax effects unless the tax court postulates that one of the parties will experience a deleterious economic effect of a near term and probable sale or disposal of the disputed asset.

The cornerstone for this approach may well be the Fonstein case in which the California Supreme Court held that the trial court is not required to speculate on the sale or disposal of an asset unless there is proof “that a taxable event has occurred during the marriage or will occur in connection with the division of the community”.[1]

It should be noted, that the Fonstein case involved the hypothetical sale of the husband’s interest in a law partnership at some unspecified future date.  In ruling that the tax consequences of such an uncertain transaction need not be taken into consideration, the court fell back on the language used in a prior decision[1], stating that “an immediate and specific tax liability must be present” in order for such consideration to be granted.  This remains the rule in California as of the date of this writing.

To summarize, the tax consequences of dividing property in divorce may be used as a negotiating tool between the divorcing parties, but depending on the immediacy and certainty of such circumstances coming to pass, the courts may or may not take them into consideration.

The practitioner should also note that these rules vary by state, so it may be necessary to consult outside legal counsel to obtain an understanding of the rules in the jurisdiction for the case at hand.

Have a question? If you would like a copy of this article in its entirety with footnotes, please contact David Ellis, Ellis & Ellis CPAs.

David Ellis is a practicing CPA in Pasadena, California.  He can be contacted at (626)577-4404 or david@ellisandelliscpas.com .

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(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.)

David Ellis is the managing partner of Ellis & Ellis, CPAs, Inc. located in Pasadena, California. He has over 25 years of experience in the practice of Divorce, Trust/Estate, and other family tax matters. He is an advisor in matters pertaining to Trust, Estate, and Corporate Taxation to the Los Angeles County Office of the Public Guardian. The firm also provides other general tax services and IRS representation. He earned his Bachelor’s Degree from the University of Southern California in Communication Arts and Sciences. He is a frequent writer and speaker on various tax subjects, and has provided continuing education services to other CPAs and tax professional in the area of Divorce, Trust, and Estate Taxation. An article that he recently co-authored entitled The Tax Consequences of Dividing Marital Property can be found in the December 2014 issue of Practical Tax Strategies, a national professional tax publication.

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