I. General Rules
Under §1041 of the Internal Revenue Code (IRC), the general rule is that neither gain nor loss is recognized on transfers of property between spouses or ex-spouses “incident to a divorce.” A transfer “incident to a divorce” is one that occurs within one year of the divorce and not more than six years from the divorce. If it occurs after six years but it is clear from the divorce agreement that the transfer is related to the divorce, §1041 still applies.
Under §1041, the gain or loss is deferred and the transferee former spouse gets a “carryover basis” – that is, the transferee assumes the transferor’s tax basis in the property at the time of transfer and such tax basis is carried over for income tax purposes.
A caveat — the deferral benefits of §1041 do not apply where the transferee spouse is a “non-resident alien.” A spouse who is not a U.S. citizen and has no permanent resident (“green card”) status may be considered a non-resident alien if they do not meet the “substantial presence” test. IRS Publication 519 (2018).
Simple enough. But there are multiple exceptions to §1041’s non-recognition rule – each of which should be carefully scrutinized when dividing assets in a divorce.
A. Sale of Marital Home
In dealing with the sale of the principal marital residence in the context of a divorce, §1041 does not apply. Rather, we look to IRC §121 — which provides that a taxpayer can exclude up to $250,000 of capital gain from the sale of the principal residence if filing a separate tax return, or up to $500,000 for a joint return, provided the following requirements are met:
During the five-year period ending on the date of the sale or exchange, the residence must have been owned by either spouse and used by both spouses as their principal residence for periods aggregating two years or more.
An individual shall be treated as using property as such individual’s principal residence during any period of ownership while such individual’s spouse or former spouse is granted use of the property under a divorce or separation instrument.
If a residence is transferred to a taxpayer incident to a dissolution of marriage, the time the taxpayer’s spouse or former spouse owned the residence is added to the taxpayer’s period of ownership.
The exclusion can only be applied to one residence every two years.
B. Retirement Assets
Retirement assets such as a 401-k or 403-b are not covered by §1041 but, rather, by a law called ERISA; as such, they cannot be divided except by a qualified domestic relations order (QDRO) incident to a divorce. The division, which creates an account for the non-participant spouse (called the “alternate payee”), does not trigger tax consequences so long as no distribution is made.
IRA’s, on the other hand, are not covered by ERISA and, therefore, do not require a QDRO in order to be divided. In dividing an IRA, be certain not to liquidate the account. Instead, do a trustee-to-trustee transfer (a direct transfer) of the IRA funds, moving them directly from one spouse’s IRA to the other spouse’s account. That way, the IRA will be split and there will be no tax liability for either spouse.
In most cases, post-division distributions from ERISA and non-ERISA plans will trigger tax consequences to the distributee at ordinary income rates. For recipients under 59½ years of age, an additional ten percent early distribution penalty will also apply. The early distribution penalty is an amount equal to ten percent of the early distribution.
Alternate payee spouses who require immediate cash from a retirement plan post-divorce can look to IRC 72(t) for relief. Under that provision, distributions to a former spouse from an ERISA plan pursuant to a QDRO will be subject to ordinary income tax — but are exempt from the ten percent penalty tax even if the recipient is younger than 59½ years of age.
C. Assignment of Income Doctrine
Another exception to the non-recognition rule of §1041 is the assignment of income doctrine. A bedrock principle of tax law is that the person who earned the income is taxed on it regardless of who receives the proceeds. The assignment of income doctrine is implicated when the right to receive the income has already accrued, and the parties assign that right to the spouse who did not earn the income.
1. Income Producing Property
Consider a divorce where the husband owns income-producing rental property and he assigns the rental income to the wife on the assumption that this will shift the income to her and she, then, will pay taxes at her lower tax rate. Under the assignment of income doctrine, that will not work. In order to achieve the objective that she pays taxes on the rental income at her tax rate, she would have to own the property. Another income-shifting strategy, of course, would be to pay alimony which will continue to be deductible to the payor and includable to the payee for agreements through the end of 2018.
2. Savings Bonds
An ostensibly simple transfer of savings bonds is anything but simple. A spouse who transfers U.S. savings bonds to a former spouse incident to a divorce must recognize as income in the year of transfer the deferred, accrued, and unpaid interest attributed to the bonds.
3. Other Assets Not Capable of Being Assigned
Particularly with highly compensated employees, a variety of other income-producing assets are typically not permitted to be assigned to others. Examples of these include: non-qualified deferred compensation plans, stock options, and restricted stock units. With these assets, the owner is liable for taxes based on the realization of income. And the support is usually paid to the non-owner spouse when the income is realized as well.
D. Corporate Redemptions
As noted, §1041’s non-recognition rules apply to transfers of property between spouses in a divorce. Therefore, a transfer of ownership of a closely held business in divorce does not trigger gain or loss if it is directly between the spouses. Alternatively, a transaction involving a spouse who transfers shares to the corporation in exchange for redemption proceeds triggers rules that are much more complex.
In the event a transfer directly between spouses is not feasible or appropriate and a corporate redemption is necessary, one of the spouses must pay the taxes. The good news is that the regulations allow divorcing couples to elect the tax treatment they want — to decide how (and to whom) the stock redemptions will be taxed. For example, depending on certain factors, the couple can either elect to have the transferor or transferee spouse taxed on the redemption proceeds. 26 C.F.R. §§ 1.10412(c).
Tax issues in divorce can be complex and mistakes costly. Make sure your attorney has a grasp of these laws before you decide to hire them.