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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 

A.  The Exchange of property between spouses and former spouses is generally tax free. If the property transfer is between former spouses, it must be incident to their divorce.1 Note: Code section 1041 is mandatory. There is no electing out of it. It also applies to the nonrecognition of loss as well as gain.

B. Transfer of property is incident to divorce if it:

  1. Takes place within one year of the date of the final decree of divorce or separation or is related to the end of the marriage.[1]                                                                                                                          a) The date of the Final Decree of Divorce or Separation is governed by State Law.
    b) Transfers within one year of such date are automatically considered to be “incident to the divorce.
    c) There is a carryover of basis in the transferred property.[2]

Example: Ricky owned separate property in the form of land that he inherited with a basis of $100,000. As part of a global divorce settlement, it is agreed that he will transfer this property to his soon to be former spouse, Lucy.  Lucy’s basis in the property becomes $100,000, regardless of its Fair Market Value.  Even if the property is subject to a mortgage that Lucy assumes, her basis in the property remains at $100,000.

  1. The Six Year Rule

Property transferred between former spouses within six years of date of termination of the marriage under the terms of a written divorce or separation agreement, is deemed to be related to the end of the marriage, and is therefore considered to be a

Section 1041 Transfer.[3]

  1. Rebuttable presumption exist that transfers made after six years are not related to the end of marriage.[4]
  2. Transfers after year one of the end of the marriage must be made under a written divorce or separation agreement, or modification thereof.

II.  Section 1041 Nonrecognition Specifics 

Transfers that take place under the protection of IRC Section 1041 result in no recognition of gain or loss to the transferor or transferee. This is true regardless of the type of property or the manner in which title to the property is held. The transferee assumes the transferor’s basis and holding period.

  1. Basis and Holding Period Carryover
    1. Under Section 1041, the transferor’s basis and holding period carryover to the [1]
    2. Carryover of basis and holding period apply regardless of Fair Market Value of the property.[2]

Example: Assume the same facts as in the previous example, except that shortly after inheriting the land with a basis of $100,000, Ricky had transmuted the property into community property with Lucy. The couple subsequently divorced and Lucy was awarded 100% of the property under the terms of the divorce decree. Lucy’s carryover basis in the property remains at $100,000. The same would be true even if the fair market value of the property was greater than the basis. For example, if the Fair Market Value of the property was $900,000 and Lucy were to pay Ricky $450,000 for his one-half ownership, Ricky would recognize no gain or loss on the transfer and Lucy’s basis would remain at $100,000. The result would be the same if Lucy traded other property or her right to alimony in return for Ricky’s one-half ownership in the property.

B. Major Exceptions To Nonrecognition Of Gain Or Loss

Tax Trap Alert: Be sure that transfers involving cash do not inadvertently become alimony. Practitioners should consider adding language to the agreement that a cash partition is not alimony.

Note: Even though Alimony is no longer taxable income to the recipient, and deductible to the payor for divorces finalized after December 31, 2018 for federal purposes, state law may still be operating under the federal rules that were in effect prior to passage of the Tax Cuts and Jobs Act (TCJA).  Such is the case in California, which does not comply to the TCJA.

(To Be Continued In Dividing Property In Divorce Tax Traps)

Go To Part 2 At This Link 
Go To Part 3 At This Link

Have a question? Contact David Ellis, Ellis & Ellis CPAs.

(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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