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. 

1. Major Exceptions to Nonrecognition of Gain or Loss
   1. Transfers to trust in which property’s liabilities exceed basis.[1]
      1. Gain is recognized by transferor.
      2. Gain equals the amount by which property’s liabilities exceed basis.
      3. Trust increases its’ basis in the transferred property by the amount of gain
   2. Transfer to Trust of Installment Instrument
      1. Transferring spouse recognizes untaxed built in gain upon transfer.^[2]
      2. Trust takes carryover basis plus trust gets increase in basis by the amount of gain recognized by transferee.[3]
      3. Post transfer interest income paid on installment instrument is taxable to trust.[4]
      4. Example: Transfers to Trust in Which Liabilities Exceed Basis.

Ward and June are in the process of getting a divorce. Ward inherited as separate property, a Japanese Samurai Sword that his grandfather brought back from World War I as a war trophy. The sword has an estimated Fair Market Value of $750,000.

Ward’s basis in the sword is $100,000, and he has pledged it as security for a business loan in the amount of $500,000.  As part of the divorce settlement, Ward transfers the sword to a trust for the benefit of June. The trust assumes the loan on the sword. Ward must recognize a gain of $400,000 on transfer calculated as follows:

Sword’s Basis:                                 $100,000
Minus Sword’s Collateralized Debt:    $500,000                                  Equals Sword’s Liabilities in Excess
of Basis and Recognized Gain:         <$400,000>

The trust’s basis in the sword becomes $500,000 calculated as Ward’s original basis of $100,000 plus the recognized gain on transfer of $400,000.

Tax Trap Alert:  With the transfer of property to a trust in which the property’s liabilities exceed its basis, the transferor spouse has the worst of both worlds. He/she must pay the tax on the recognized gain, while their spouse receives the property at the stepped-up basis without paying any of the associated tax.

Example: Transfer of Installment Obligation to a Trust
Rob and Laura are in divorce proceedings. Rob owns, as a separate property, an installment note with a basis of $100,000 and a face value of $500,000, therefore, there is $400,000 of deferred gain built into the obligation. Pursuant to the divorce settlement agreement, Rob transfers the note to a trust established for the benefit of Laura. Rob must immediately recognize the $400,000 gain in spite of the fact that he has not, and will not receive these funds. The trust will not recognize any gain on transfer, and likewise neither will Laura. The trust basis in the note is Rob’s original basis of $100,000 plus the $400,000 gain recognized by Rob on the transfer.

Tax Trap Alert: For the transferring spouse, the transfer of an installment note to the transferee spouse’s trust in a divorce situation represents the worst of both worlds. The transferring spouse is giving up the right to the future stream of income, while at the same time paying tax on it up front. The recipient spouse, on the other hand, via the trust, receives the gain portion of the installment obligation tax free, as well as a step up in basis.

In the author’s opinion, an argument could be made that the immediate recognition of gain upon the transfer of installment obligation to a trust rules do not apply to transfers to a grantor trust. This is because under IRC Section 671 to 679 and related Revenue Rulings, grantor trusts are ignored for income tax purposes. If the client insists on making a transfer to a trust, care should be taken by the practitioner to verify that before gain is recognized it is confirmed that the trust to which the installment instrument is transferred is a non-grantor trust. Taxpayers contemplating such transfers should consider requesting a private Letter Ruling from IRS – especially if the dollar amounts involved are large. Often clients will have established grantor trust or so called “living trusts” for probate avoidance or the like, and such clients and perhaps even their advisors may not be aware of or understand the difference between a grantor and nongrantor trust for tax purposes. However, even if grantor trust status is confirmed, at a minimum, the client should be made aware of the tax risk of this transaction.

3.Transfers to a Nonresident Alien Spouse

Property Transfers to a nonresident alien spouse do not receive nonrecognition treatment.[1]  The transferring spouse may recognize gain or loss and the transferee spouse will receive a step up or step down in basis.

Tax Trap Alert: It may still be possible to achieve nonrecognition of gain or loss on property transfers to nonresident spouse using the Gift Tax Rules. Caution should be exercised in this situation as the Gift Tax Rules pertaining to nonresident alien spouses are different for resident alien spouses, than for U.S. Citizens.

Go To Part 1 In This Series

Go To Part 3 In This Series

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

(All footnotes will be posted at end of series! 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.)