Tax Issues When Dividing Property During Divorce

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The issue of taxes, and what is deductible and what is not, often comes up between divorcing couples. This article will address the transfer of assets between spouses.

While most asset transfers between spouses (or former spouses) in the context of a marital dissolution will be non-taxable, there are some important exceptions. For example, this rule does not apply when the recipient spouse is a non-resident alien. Transfers between former spouses which occur more than six years from the date of the divorce will be taxable unless the taxpayer shows that they are incident to the divorce. Lastly, a person cannot avoid paying taxes on a vested right to income by assigning the right to receive that income to his or her spouse.

Generally speaking, the Internal Revenue Code (section 1041) provides that a transfer between spouses, or former spouses, “incident to divorce” is not taxable in most circumstances. Instead, the transfer is treated like a gift. The transferee takes the transferor’s tax basis in the property. The effect of the rule is to defer the tax consequences (recognition of gain or loss) until the transferee disposes of the property. For more information on the tax code and your divorce, contact expert Los Angeles family lawyers.

In further detail, Section 1041 applies to all transfers between spouses and also to transfers between former spouses, in  situations that are incident to the divorce. Legally speaking, a transfer of property is “incident to the divorce” if the transfer (1) occurs within one year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage.

A transfer is “related to” the cessation of the marriage when the transfer is required under the divorce or separation instrument, and the transfer takes place within six years from the date of the divorce.” If the transfer is not made pursuant to a divorce or separation instrument, or occurs more than six years after cessation of the marriage, it is presumed to be unrelated to cessation of the marriage. The presumption may be rebutted “by showing that the transfer was made to effect the division of property owned by the former spouses” at the time their marriage ceased.

When the spouse who receives property “incident to divorce” is a nonresident alien, taxable gain will be recognized on the transfer. In other words, the spouse making the transfer will be taxed on the difference between the fair market value of the property transferred and his or her adjusted tax basis in the property. The IRS treats nonresident aliens differently because it there may be little chance that the gain is ever reported or that tax will be paid.

To discuss your tax-related divorce issue, contact the Los Angeles family lawyers at Walzer Melcher LLP today.