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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When two people fall in love, they tend to be blind to life’s realities. The last thing they want to do is bring up issues that might generate conflict, and let’s face it, the topic of taxes is definitely turbulent.

Ask these tough tax questions before you get married – to avoid an inevitable divorce.

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Annette Nellen

We get used to certain rules in the tax system and then think they HAVE to be there. But, often, that is not the case. I think the rules related to divorce are good examples.

Alimony is deductible by the payer and taxable to the recipient. This violates the “fruit of the tree” doctrine from the famous 1930 US Supreme Court case, Lucas v Earl.

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Debra Thompson

Newlyweds and the recently divorced should make sure that names on their tax returns match those registered with the Social Security Administration (SSA). A mismatch between a name on the tax return and a Social Security number (SSN) could unexpectedly increase a tax bill or reduce the size of any refund.

Newlyweds and the recently divorced should make sure that names on their tax Read More

Incident to a divorce, one question that must be settled between the two spouses is “Who gets to claim the children on their taxes?” It is most commonly thought that reference to the divorce decree (Qualified Domestic Relations Order or QDRO). However, this may not be the case.

Under IRS rules children of unmarried parents are claimed as dependents on the custodial parent’s return. The custodial parent is determined strictly by a time test. The qualifying child must have the same principal place of residence as the taxpayer for more than half the year if the taxpayer is to qualify as the custodial parent. Read More

All too often, family law courts make rulings that are contradictory to federal tax law, causing confusion and inequity in divorce actions since family court rulings cannot trump federal tax law.

An issue for divorced parents is who gets to claim the children for tax purposes. Federal tax law provides that the parent with physical custody claims the child unless that parent releases the exemption to the other parent. Frequently, family courts award physical custody to one parent and the tax exemption to the other. To make matters worse, the courts assume that the exemption deduction will provide a financial benefit to the non-custodial parent. Then the court adjusts child support accordingly, leaving the non-custodial parent with two unpleasant surprises when filing his or her tax return: the Read More

iStock_his hersXSmall“A” is for alimony.  I hope you live happily ever after with your first spouse, but statistics suggest divorces do happen about half the time.  When there is a divorce there is often alimony as part of the divorce decree.  A divorce decree often has several items with tax implications depending on the family situation.  It’s important that you understand those tax implications before you sign the divorce decree.

Alimony is a fixed sum of money paid from one spouse to the other spouse.  If it is defined as alimony in the divorce decree, it is ordinary taxable income for the spouse that receives the alimony.  Since it’s income for one spouse, the spouse paying the alimony gets an above-the-line tax deduction.  If it’s not defined as alimony or spousal maintenance in the divorce decree, then it’s probably going to be child support.  Obviously having children is the key to having child support.  The lower income spouse receiving the payments will want them to be child support with no income tax to pay, so the two parties have inverse desires to classify payments as child support or alimony which is why the resulting compromise is often some of each.

Any property settlements or lump sum payments as result of the divorce are going to have no tax consequences.  The other thing that will have some tax consequence is claiming the kids.  The divorce decree will indicate which spouse can claim the children as dependents, which can make numerous differences on their tax return.  If the noncustodial parent is going to claim a child as a dependent, the custodial parent will need to complete Form 8332, and the divorce decree might make that form part of the requirements of the custodial spouse. Read More

House and lawAs if divorce were not a stressful enough time, the complexities of the US tax rules when a non-US spouse is involved just make it all the more unbearable.

Here are the US Tax basics to keep in mind with respect to property transfers. (Payments of alimony will be the subject of another tax blog posting).

You May Have Both Income Tax and Gift Tax Issues

Under the general US tax rules, asset transfers between spouses incident to a divorce are tax-free under Code Section 1041. There is no realization of a gain or loss by the transferor-spouse upon such a transfer of property. Instead, the transfer is treated as a “gift”. If the spouses are both US citizens, the case is straightforward and simple – no US Income tax or Gift tax consequences will result. Not so simple if one spouse is a non-US citizen and even more complex if the non-citizen spouse is also a “nonresident” alien (NRA).

A transfer is treated as incident to a divorce if it takes place within a year of the divorce or is “related to the cessation of the marriage”. Generally, a transfer is related to the cessation of the marriage if it is pursuant to a divorce or separation agreement and occurs not more than 6 years after the date on which the marriage ceases.

Very significantly, in order for the income tax-free treatment of Code Section 1041 to apply, the recipient of the property cannot be a “nonresident alien” (NRA). For example, if you transfer appreciated stock to your NRA spouse as part of the divorce settlement, you will have to pay tax on the inherent gain in the stock, generally just as if you sold it. In addition you may have Gift Tax consequences. Read More

Marital Estate Division Offers Challenges and Opportunities For Advisors

The emotional aspects of a divorce often interfere with planning for the efficient distribution of the marital estate. The shock and ill feelings may create a barrier between spouses that prevents even discussing issues. Tax practitioners need to know how to explain to a divorcing client the tax realities, to avoid any post-divorce tax surprises. Mistakes in property division or fraud can produce consequences that the tax practitioner may be unable to reverse.

This is Part III in a three part series.  See Part I and Part II.


Sec. 71(b)(1) defines alimony as a transfer of cash made under a divorce or separation instrument to a spouse or former spouse under the following conditions:

1.  The divorce or separation instrument does not designate the payment as anything other than alimony (not for child support).
2.  The payments do not continue after the death of the recipient.
3.  The provisions of the instrument do not preclude a deduction by the payor spouse and the recognition of income by the payee spouse.
4.  Spouses who are legally separated under a decree of divorce or separate maintenance do not live in the same household when the transfer is made.

Certain payments to third parties on behalf of the spouse—for example, mortgage payments—qualify as payments in cash. Alimony does not include: child support payments (which are generally nondeductible by the payer and not included in the recipient’s gross income), non-cash property settlements, payments that are part of the community income of the payee, payments to maintain the payer’s property for use by the payee, or the value of such use. If the parties are married at the end of the tax year and file a joint return, payments made during the year do not qualify as alimony. Generally, alimony is deductible by the payer and included in the recipient’s gross income. Thus, there is inherent tension between property settlement and alimony. the payor may want a low property settlement and high alimony amounts for the tax deduction. The payee spouse, however, wants the reverse—that is, a property settlement not includible in income rather than taxable alimony.

To make property payments deductible, the payer spouse may try to disguise the payments as alimony. For example, the payer may make large “alimony” payments Sec. 71(f) prohibits excessive front-loading of alimony payments and requires the payer spouse to recharacterize (or “recapture”) part of the alimony payments as nondeductible property transfers if there is excessive front-loading. Tax advisers can help their divorcing clients by reviewing any nonuniform payment schedule to make sure it does not violate the anti-front-loading rules.

Ensuring Safety

In planning for the division of assets and the obligations of the parties, safeguards can be put into place to avoid failed expectations. For example, parties may contractually decide that new life insurance is needed to fulfill the payer’s alimony and child support payment obligations in the event of death. The parties may contract to leave the ex-spouse as beneficiary (hanging beneficiary) on life insurance policies and retirement plans to ensure that the ex-spouse receives his or her bargained-for interests. If the beneficiary is designated as “my current spouse” and the owner spouse remarries, the ex-spouse no longer receives his or her interest when death or retirement occurs.

Safeguards also may be needed when a payer spouse has cyclical income business interests or illiquid business interests; the spouses may agree that an alimony trust or maintenance trust (Sec. 682 trust) is the best solution. An alimony trust can protect the payee (ex-spouse) from the death or financial insolvency of the payer before all of the payments have been made.

Emerging Whole

Spouses in divorce situations must disclose all property, and this property must be distributed to the proper party. When fraud, errors, or omissions occur, a CPA needs to be capable of helping his or her client avoid the negative tax consequences of transfers or payments made in connection with the divorce. The client’s objective is to emerge from the divorce economically whole while minimizing taxes.

Divorce Issues Checklist

Among the many tax practice resources the AICPA makes available to Tax Section members (see Resources box at the end of this article) is an eight-page checklist of tax considerations for CPAs representing clients who are divorcing or recently divorced. Some of its points are:

1.  Determine which party to represent and prepare a new engagement letter, privacy disclosure notice, power of attorney, and similar documents.
2.  Consider obtaining conflict-of-interest releases where indicated.
3.  Review any prenuptial agreement.
4.  Consider the effect of joint liability for any taxes owed.
5.  Consider the need for (or, if completed, obtain a copy of) a qualified domestic relations order for any individual retirement accounts and other retirement plans.
6.  If there are children with investment income, reevaluate “kiddie tax” implications.
7.  For a property settlement, obtain or prepare a schedule of assets with tax considerations for each asset.
8.  Consider the effect of divorce on insurance coverage, beneficiary designations, mortgages and other debts, financial and estate planning, etc.

Source: Divorce Issues Checklist, AICPA Tax Section.

Executive Summary

CPAs can provide forensic services and/or tax advice concerning identification and division of marital property for a client going through a divorce. Since divorcing spouses are likely to have competing interests, however, CPAs providing these services should take care to avoid conflicts of interest.

In the nine community property states, property is owned concurrently between spouses. In the rest, referred to as common law states, courts must determine an equitable distribution of the spouses’ property between them.

Property transfers by a spouse during a period of marital strife may be subject to heightened judicial scrutiny in an equitable distribution of property. A court may invalidate transfers made to deprive the other spouse of assets by fraud or dissipation.

A transfer incident to divorce from one spouse to the other generally will not result in taxable gain or loss. However, divorcing couples should be made aware of requirements in the Code and regulations for a transfer to be considered incident to divorce. Similarly, alimony typically entails tax planning.

by Ray A. Knight, CPA, J.D. and Lee G. Knight, Ph.D. (April 2013)

and posted by Harold Goedde CPA, CMA, Ph.D. (taxation and accounting)