There are currently nine states that have community property laws. Every state’s specifics are slightly different, some more or less stringent then others. For the most part, from an income tax standpoint, community property laws mean that anything earned or purchased while the “community” or marriage was intact is split 50/50. This is a big issue in the disposition of property and/or business, which we will discuss later. If you are completing a return either in or for someone in a community property state you should research that state’s specific laws.
When preparing a tax return, some states require that a separately filed return have all income from the community split equally onto the different returns and some do not. In order to file a separate return you must have the name and SSN of the other spouse to put on the return. The estranged spouse is required to provide this information and can be fined by the IRS for failure to do so. In order to file the Form 8958 (Allocation of Tax Amounts Between Certain Individuals in Community Property States) must be completed with both spouses income and withholding listed. If the other spouses information is not available the Form 8958 should be completed with the available information and the return will not be able to be filed electronically, but must be mailed in with a statement that the other spouses information was not available and the reason.
Division of Property
The division of marital property is a subject we as tax professional do not usually have to get involved with on the front end. We, however, do get involved after the court has made a decision. IRC Cod. Sec. 1041 discusses the transfer of property between spouse or incident to a divorce.
The general rule is that transfers between spouses or former spouses (incident to a divorce) will recognize no gain or loss on transfer. In order to be considered incident to a divorce the transfer of property must occur within one year of the date of divorce or be directly related to the cessation of the marriage. Unless specific circumstances can be proven a transfer after one year but directly related to the cessation of the marriage, must occur within six years of the date of divorce. These rules also apply to annulments.
When a transfer of property (real, personal, tangible or intangible) incident to a divorce occurs the person receiving the property has a basis that is equal to the adjusted basis immediately before the transfer in the hands of the other party. Therefore any computation of gains, losses, or depreciation will be based on the adjusted basis in the hands of the transferor.
When dealing with the division of property incident to divorce business or investment property can come into the picture. For the most part the same rules apply as above. Basis, gain, loss, depreciation, or carryovers will be the same in the hand of the person receiving the property as the person transferring it.
This rule applies to items such as capital loss carryovers, rental property with passive losses, assets in Qualified Joint Ventures, Partnerships, S-Corporations, and Net Operating Losses. If a piece of property that is transferred incident to divorce has a liability attached (an outstanding loan, etc) the liability does not effect the basis. However, if the transferee assumes responsibility for the liability all the tax implications (deduction of mortgage interest, business interest, etc) are also transferred.
One large item, that is overlooked until it is too late in many divorce proceedings, is the tax implication of the distribution from one or the other partners retirement account. In many cases the decree simply orders one spouse to pay the other spouse an amount equal to the appropriate percentage in the account at the time of the separation. Other times, there is a direct order to the administrator of the account to disburse the holding for division. And other times the court, or the attorneys, actually get it right, and have a Qualified Domestic Relations Order (QDRO) drawn up.
A QDRO allows the administrator of the account to make the ordered distribution to the appropriate spouse and to code the reporting documents to avoid the 10% early withdrawal penalty. This order, when appropriately worded, also gives the receiving spouse the opportunity to roll the distribution into a qualified retirement account of their own, thereby deferring the taxes until they need the income. I have seen clients that just cashed in their 401(k) and gave the ex-spouse half because that is what the court order said. Then they get hit with the taxes and penalties at the end of the year as well. Unless these orders as well written that does not count as alimony.
Last but not least, How you can help your clients up front.