6.7 Property Transfers Between Spouses and Ex-Spouses

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.

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image Planning Reminder
Recipient Spouse Bears Tax Consequences of Transferred Property
Under the tax-free exchange rules, the transferor-spouse does not have taxable gain or deductible loss on the transfer of property, even if cash is received for the property or the other spouse (or former spouse) assumes liabilities or gives up marital rights as part of a property settlement. The spouse who receives property may incur tax on a later sale because his or her basis in the property is the same as the transferor-spouse’s basis; see the Examples in 6.7. Because the transferee bears the tax consequences of a later sale, he or she should consider the potential tax on the appreciation in negotiating a marital settlement. In a marital settlement, the transferee spouse can lessen the tax burden by negotiating for assets that have little or no unrealized appreciation.
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EXAMPLES
1. In a property settlement accompanying a divorce, a husband plans to transfer to his wife stock worth $250,000 that cost him $50,000. In deciding whether to agree to the transfer, the wife should be aware that her basis for the stock will be $50,000. if she sells the stock for $250,000, she will have to pay tax on a $200,000 gain. This tax cost should be accounted for in arriving at the settlement.
2. Basis of the property in the hands of the transferee-spouse is not increased even if cash is paid as part of the transfer. For example, a husband received a house originally owned by the wife as part of a marital settlement. Her basis for the house was $32,200. He paid her $18,000 cash as part of the settlement and when he later sold the house for $64,000, he argued that his basis for purposes of computing profit was $50,200—the wife’s $32,200 basis plus his $18,000 cash payment. The IRS refused to consider the cash payment as part of basis, and the Tax Court agreed that the carryover basis rule applies.

Nonresident alien.

The tax-free exchange rule does not apply to transfers to a nonresident alien spouse or former spouse.

Transfers of U.S. Savings Bonds.

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.

Payment for release of community property interest in retirement pay.

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.

Transfers in trust.

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.

Sole proprietorship sale to spouse.

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.

Transfer of nonstatutory options or nonqualified deferred compensation.

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.

Divorce-related redemptions of stock in closely held corporation.

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.

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image Court Decision
Interest on Marital Property Settlements
Parties may agree to pay interest on property transfers relating to divorce settlements when payments are to be made over time. The actual property transfer is generally a tax-free exchange. According to the Tax Court, the interest is separate and apart from the property transferred. The deductibility of the interest paid depends on the nature of the property transferred. Interest allocated to residential property, for instance, is deductible as residential mortgage interest; interest allocated to investment property is deductible as investment interest subject to the net investment income limit. See Chapter 15.
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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.

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image Planning Reminder
Transfers to Third Parties
If you transfer property to a third party on behalf of your spouse or former spouse where the transfer is required by a divorce or separation instrument, or if you have your spouse’s or former spouse’s written request or consent for the transfer, the transfer is tax free to you under Section 1041. The transfer is treated as if made to your spouse or former spouse, who then retransfers the property to the third party. A written request or consent must specifically state that the tax-free exchange rules of Code Section 1041 are intended, and you must receive it before filing the tax return for the year of the transfer. As discussed in the Examples below, a divorce-related stock redemption may qualify for Section 1041 treatment as a transfer “on behalf of” the other spouse.
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EXAMPLES
1. A federal district court and the Ninth Circuit Court of Appeals held that, under Section 1041, a wife was not taxable on the redemption of her stock by the couple’s closely held corporation where the redemption was pursuant to their divorce agreement and incorporated into the divorce decree. The Ninth Circuit viewed the transfer as if the husband had received the stock directly from the wife and then transferred it to the company.
After the Ninth Circuit held that the redemption was not taxable to the wife, the IRS argued in a separate case against the nonredeeming husband that he received a taxable constructive dividend. However, the Tax Court disagreed, holding that there was no dividend to the husband because under state law he was merely a guarantor; he was not primarily and unconditionally obligated to buy the stock. The IRS did not appeal the Tax Court decision.
In this unusual situation, the IRS is in the position of being unable to collect tax on the redemption proceeds from either the transferor or transferee spouse.
2. After William and Carol Read divorced, William, pursuant to their divorce decree, elected to have their controlled corporation purchase all of Carol’s stock. A Tax Court majority held that her transfer was on behalf of William and qualified for Section 1041 non-recognition treatment.
The Tax Court majority also held that William realized a constructive dividend on the corporation’s redemption of Carol’s stock. However, the majority relied on a concession by William and did not specify a legal standard for determining whether he should be taxed. Concurring judges suggested that constructive dividend treatment for William followed automatically from the holding that Carol’s stock transfer was on his behalf and thus within Section 1041. There were four dissenting opinions, all of which held that under traditional law for constructive dividends, there is no constructive dividend unless William had a “primary and unconditional obligation” to buy the shares, an obligation the corporation satisfied by making the redemption. Most of the dissenters argued that William did not have such an obligation and should not be taxed. They further argued that if William was not obligated to buy the shares, Section 1041 does not apply and thus Carol realized capital gain on the redemption of her shares. Other dissenting judges held that a spouse can never avoid taxable gain under Section 1041 on a redemption incident to divorce.
3. The Eleventh Circuit Court of Appeals allowed tax-free treatment to a redemption of a wife’s stock, following the Tax Court majority in Read (Example 2 above). The redemption was on behalf of her ex-husband. The redemption was required by their divorce decree and it left him in control of 98% of the corporation’s stock. He had guaranteed the corporation’s 10-year promissory note to her, and the terms of the note specifically said that the guarantee was in his interests.
Furthermore, although the corporation’s note did not provide for interest, interest income was not imputed to the wife. Imputed interest does not apply where the underlying transfer is not taxable under Section 1041.

Basis of property received before July 19, 1984, or under instruments in effect before that date.

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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