Under Section 1041, all transfers of property between spouses are treated as tax-free exchanges, other than transfers to a nonresident alien spouse, certain trust transfers of mortgaged property, and transfers of U.S. Savings Bonds; these exceptions are discussed below. Section 1041 applies to transfers during marriage as well as to property settlements incident to a divorce. In a Section 1041 transfer, there is no taxable gain or deductible loss to the transferor spouse. The transferee-spouse takes the transferor’s basis in the property, and so appreciation in value will be taxed to the recipient on a later sale. This basis rule applies to all property received after July 18, 1984, under divorce or separation instruments in effect after that date.
A transfer is “incident to a divorce” if it occurs either within one year after the date the marriage ceases or, if later, is related to the cessation of the marriage, such as a transfer authorized by a divorce decree. Any transfer pursuant to a divorce or separation agreement occurring within six years of the end of the marriage is considered “incident to a divorce.” Later transfers qualify only if a transfer within the six-year period was hampered by legal or business disputes such as a fight over the property value.
The tax-free exchange rule does not apply to transfers to a nonresident alien spouse or former spouse.
The IRS has ruled that the tax-free exchange rules do not apply to transfers of U.S. Savings Bonds. For example, if a husband has deferred the reporting of interest on EE bonds and transfers the bonds to his ex-wife as part of a divorce settlement, the deferred interest is taxed to him on the transfer. The wife’s basis for the bonds is the husband’s basis plus the income he realizes on the transfer. When she redeems the bonds, she will be taxed on the interest accrued from the date of the transfer to the redemption date.
The Tax Court allowed tax-free treatment for a payment made to a wife for releasing her community property claim to her husband’s military retirement pay. The IRS had argued that the tax-free exchange rules discussed in this section did not apply to the release of rights to retirement pay that would otherwise be subject to ordinary income tax. The Tax Court disagreed, holding that the tax-free exchange rule applies whether the transfer is for relinquishment of marital rights, cash, or other property.
The tax-free exchange rules generally apply to transfers in trust for the benefit of a spouse or a former spouse if incident to a divorce. However, gain cannot be avoided on a trust transfer of heavily mortgaged property. If the trust property is mortgaged, the transferor spouse must report a taxable gain to the extent that the liabilities assumed by the transferee spouse plus the liabilities to which the property is subject (even if not assumed) exceed the transferor’s adjusted basis for the property. If the transferor realizes a taxable gain under this rule, the transferee’s basis for the property is increased by the gain.
Tax-free exchange rules may apply to a sale of business property by a sole proprietor to a spouse. The buyer spouse assumes a carryover basis even if fair market value is paid. The transferor is not required to recapture previously claimed depreciation deductions or investment credits. However, the transferee is subject to the recapture rules on premature dispositions or if the property ceases to be used for business purposes.
According to the IRS, if a vested interest in nonstatutory (nonqualified) stock options or nonqualified deferred compensation is transferred to a former spouse as part of a property settlement, the transferor-spouse (the employee) does not have to report any income; the Section 1041 tax-free exchange rules apply. When the transferee-spouse later exercises the options or receives the deferred compensation, he or she will be taxed on the option spread (2.17) or the deferred compensation as if he or she was the employee. Income tax withholding and FICA tax withholding (Social Security and Medicare taxes) is generally required from the payments made to the transferee-spouse.
When a married couple own all (or most) of the stock in a closely held corporation, the corporation may redeem the stock of one of the spouses as part of an overall divorce settlement. Does the transferring spouse avoid tax on the redemption under the Section 1041 tax-free exchange rules?
If the redemption of one of the spouses’ stock is treated as a transfer to a third party on behalf of the other spouse, Section 1041 applies and the transferor-spouse would escape tax on the redemption. However, there has been much confusion and litigation as to the standards for determining whether a redemption is “on behalf of” the non-transferor spouse, and whether different tests should apply for determining the tax treatment of each spouse. Court decisions have generally supported tax-free treatment for a spouse whose stock is redeemed under the terms of the couple’s divorce or separation instrument, or where the other (non-transferring) spouse requests or consents to the redemption. However, the courts are divided on the issue of whether the non-transferor spouse, who is left in control of the corporation, has realized a constructive dividend as a result of the redemption. See Example 2 below for the disputed positions taken by Tax Court judges in the Read case.
In response to the inconsistent standards used by the courts (see the Examples below), the IRS amended its regulations to provide a specific rule for determining which spouse will be taxed on the redemption. The regulation allows tax-free exchange treatment under Section 1041 to the transferor spouse (whose stock was redeemed) only if under applicable law the redemption is treated as resulting in a constructive dividend to the non-transferor spouse. If constructive dividend treatment does not apply to the non-transferor spouse, the form of the redemption transaction is followed and the transferor-spouse taxed on the redemption. The IRS regulation adopts the position of some of the dissenting judges in the Read case; see Example 2 below. The spouses are allowed to provide in a divorce or separation agreement that the redemption will be taxable to the nontransferor spouse even if the redemption would not result in a constructive dividend to that spouse under applicable law. Alternatively, they can provide that the transferor will be taxed on the redemption although the redemption would otherwise be treated as a constructive dividend to the nontransferor spouse.
The tax-free exchange rules do not apply to property received before July 19, 1984, from your spouse (or former spouse if the transfer was incident to divorce). Your basis for determining gain or loss when you sell such property is its fair market value when you received it. The same fair market value basis rule applies to property received after June 18, 1984, under an instrument in effect on or before that date unless a Section 1041 election was made to have the tax-free exchange rules apply. For property subject to such an election, your basis is the same as the transferor-spouse’s adjusted basis.
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