Volume 18, Number 3
TAX CONSEQUENCES OF REAL ESTATE TRANSACTIONS IN DIVORCE
John J. Weiler
Divorce usually involves both a personal separation and a separation of assets. This article discusses the tax consequences of common real estate transactions that a typical couple facing divorce may encounter.
Internal Revenue Code (I.R.C.) § 1041, the "Magna Carta" of this area of the tax law, was a legislative response to a U.S. Supreme Court decision holding that the transfer of appreciated property in exchange for the release of marital rights resulted in the recognition of gain to the transferor. Congress believed that, in general, it was inappropriate to tax property transfers between spouses. The I.R.C. already recognized that spouses were able to transfer property between themselves free of gift taxes. In enacting I.R.C. § 1041, Congress recognized that the existing rules had not worked and had resulted in controversy and litigation. Congress attempted to simplify the rules by treating spouses or former spouses as one economic unit; and treating the transfer of property incident to a divorce and the transfer of property between spouses, for income tax purposes, as gifts.
I.R.C. § 1041 provides that no gain or loss is recognized on a transfer of property from a spouse or a former spouse to a spouse or former spouse if the transfer is incident to a divorce. The tax treatment described by this section is mandatory and applicable to U.S. citizens and resident aliens. The parties cannot elect out of it. The section is applicable even if the spouse or former spouse pays consideration for the property by giving up rights, transferring other property, or paying cash.
It is important to note that this is also the tax treatment of property transfers between spouses during marriage.
The transferee former spouse takes the transferor's tax basis in the real property determined immediately before the gift, i.e., the tax basis is carried over for income tax purposes. This rule is applicable whether the fair market value of the real property transferred is less than, equal to, or greater than the transferor's adjusted tax basis in the property prior to the transfer.
An Illustration of the Rules
Let's say a husband and wife enter into a property settlement under which the wife is to transfer to her husband her one-half interest in the matrimonial home. Their tax basis is $200,000, and the fair market value of the house is $240,000. If the husband pays his wife cash equal to one half of the fair market value, $120,000, such payment has no tax consequences. The transaction is deemed a gift by one to the other with a carryover tax basis. The husband is deemed to have a tax basis in the house equal to their joint tax bases prior to the transfer (his one half and her one half). The wife has a tax basis in the cash equal to its value. The result is the same if the wife prior to the transfer had taken out a loan and encumbered the matrimonial home with a lien. The husband would take the real property subject to the lien; his tax basis would still be their joint tax bases prior to the transfer (his one half and her one half); and the wife would not recognize any gain on the transfer.
I.R.C. § 1041 applies to losses as well as gains: neither is recognized. This rule is applicable if the fair market value of the real property transferred is less than its tax basis. For example, a husband sells his wife real property that he owns and that has a tax basis of $100,000 and a fair market value of $70,000. If the sales price between the parties is $70,000, the husband cannot deduct the $30,000 loss. The wife's tax basis in the house is the carryover basis from the husband, $100,000. The transaction is treated as a gift. If the wife later sells the house for $70,000, she can claim a $30,000 tax loss.
If the former spouses transfer rental property in which they had previously generated passive activity losses that are suspended, special rules apply. The suspended losses are added to the tax basis of the transferred property, and neither party can deduct the losses at the time of transfer, whether or not the transferee former spouse actively participates in management of the rental property after the transfer. The suspended losses have been converted to tax basis, and the suspended activity losses are added to the tax basis of the transferred real property. In addition, the capital gain holding period is also aggregated. Thus, the transferee former spouse can add to his or her holding period, the period of time during which the transferor former spouse held the property.
The transfer of real property between spouses will not trigger depreciation recapture under I.R.C. § 1250, which provides for the recapture, at other than 20 percent maximum capital gain rates, of certain depreciation taken on the transferred real property. The section sets forth a host of different tax rates depending on when the depreciation was taken, type of property, holding period, and so forth. The transferee spouse takes the real property as a "gift," subject to the property's depreciation recapture.
Transfers to Third Parties
In order for a transfer of real property to fall within the confines of I.R.C. § 1041, the transfer has to be between spouses or former spouses and incident to a divorce, or in trust for the benefit of a spouse or former spouse incident to a divorce. The Temporary Treasury Regulations take a more expansive approach and allow the transfer of property to a third party on behalf of a spouse or a former spouse in three situations: (1) if the transfer is required by the divorce or separation instrument; (2) if the transfer to the third party is made pursuant to the written request of the non-transferring spouse or former spouse; or (3) if the transfer is made pursuant to a written consent or notification of the transfer to the third party. The consent or notification executed by the non-transferring spouse or former spouse must state that the parties intend for the transfer to be treated as a transfer to the other spouse subject to I.R.C. § 1041 and must be received by the transferor spouse prior to the date of filing the transferor's tax return for the tax year in which the transfer was made. Except for the transfers to third parties described in the previous paragraph, a transfer to a third party by a spouse or former spouse is not protected by I.R.C. § 1041 and is taxable if gain is realized on the transfer. If the transfer meets one of the three exceptions set forth in the Temporary Treasury Regulations, the transfer is treated as having been made directly to the non-transferring spouse or former spouse, who will be treated as immediately transferring the real property to the third party. This deemed transfer to the third party does not qualify for non-recognition treatment under I.R.C. § 1041. This second leg of the transfer results in the recognition of taxable income by the transferee spouse or former spouse if gain is realized.
Care needs to be exercised if the transfer of real property between spouses or former spouses involves controlled entities, in which case the question becomes whether the transfer falls within the non-recognition provision of I.R.C. § 1041. The Temporary Treasury Regulations give an example in which the property transferred came from the sole proprietorship of one of the parties, and conclude that the transaction is subject to I.R.C. § 1041. However, the Regulations take the position that a sale of property from a wholly owned corporation to a former spouse is not a transfer between parties and, therefore, not subject to I.R.C. § 1041. The Regulation goes on to provide that the step transaction doctrine may be applicable to recharachterize the transaction between the parties.
Courts have reached divergent results where an interest in an entity is bought out as part of the divorce process and the funds for the buyout come from the entity, such as when the interest of one of the parties in an entity holding real property is bought out for cash by the entity. Incidents of taxation can be allocated among the parties if they so desire. If the former spouse whose interest is being redeemed is to be taxed, then the parties should make sure that the non-redeemed spouse has no obligation to purchase the interest and that the purchasing entity is not acting on behalf of that spouse. However, if the former spouse whose interest is not being redeemed is to be taxed, then the parties need to ensure that the spouse who is not being redeemed is obligated to purchase the interest from the spouse whose interest is to be redeemed.
I.R.C. § 1041 does not apply if the transferee spouse is a nonresident alien.
Transfers Incident to a Divorce
I.R.C. § 1041 applies to transfers between former spouses if the transfer is incident to a divorce. The statute defines when a transfer meets this definition. Transfer between former spouses incident to divorce. There are two parts to the statutory test of whether a transfer is incident to a divorce. I.R.C. § 1041 provides that a transfer is incident to a divorce if (1) it occurs no more than one year after the date on which the marriage ceases, or (2) the transfer is related to cessation of the marriage.
Transfer occurring no more than one year after date on which the marriage ceases. The Temporary Treasury Regulations give a broad interpretation to the statutory phrase "transfer occuring not more than one year after the date the marriage ceases." The Regulations take the position that as long as the transfer is within the requisite one-year time period, it is not necessary that the real property transferred was owned during the marriage.
Transfer related to cessation of marriage. The Temporary Regulations take a more restrictive interpretation of the phrase "the transfer is related to the cessation of the marriage." If the transfer of property between spouses is pursuant to a divorce or separation instrument and the transfer occurs not more than six years after the date on which the marriage ceases, the transfer falls within I.R.C. § 1041.
The Temporary Regulations also take the position that one year after the divorce, a transfer of property that does not meet this test is presumed to be non-divorce related, subject to a rebuttable presumption. The parties can rebut the presumption by showing that the transfer was made to carry out the division of the marital property. Parties can voluntarily divide property whether or not a court is involved in that division.
Care needs to be exercised that the transfer is pursuant to a divorce or separation agreement. The Temporary Regulations take the position that the transfer must be pursuant to a divorce or separation instrument as defined in I.R.C. § 71(b)(2). In this section, a divorce or separation instrument is defined as a decree of divorce or separate maintenance or a written instrument incident to such a decree; a written separation agreement; or a court decree requiring a spouse to make payments for support or maintenance of the other spouse. Included in this definition is any modification or amendment of such decree or instrument.
The implication here is that only transfers that are made pursuant to or under the obligations of a written instrument fall within the I.R.C. § 1041. The statute, however, does not appear to require a written instrument (generally described as a writing containing material settlement terms), which may be set forth in a divorce decree or, more typically, is referenced in a divorce decree as a separate agreement or a written separation agreement.
Another troubling aspect of this rule is that the transfer must be made within six years or else the presumption must be rebutted. Property is often transferred after six years, for example, where a house is retained to raise children of the marriage. After the children reach a certain age, the parties dispose of the house. If the disposition of the house occurs six years after the termination of the marriage, the exception has not been met, and the presumption must be rebutted. Annulments and marriages void from the start due to violation of state law fall within the confines of I.R.C. § 1041.
It is important to keep in mind that, pursuant to I.R.C. § 1041, potential tax consequences are also transferred when transferring real property between spouses. Because the tax basis is transferred from one spouse to the other spouse, built-in gain recognized by the transferee spouse upon the disposition of the property is also transferred.
I.R.C. § 1041 does not exempt all real property transfers between spouses or former spouses. Where liabilities on the property or to which the property is subject exceed the adjusted tax basis of the property, the property cannot be transferred between the spouses without tax consequences. The taxable gain recognized by the transferor spouse is the amount by which the liabilities exceed the tax basis in the real property transferred. The tax basis of the transferee is increased by the gain recognized by the transferor.
Retirement assets and the marital home are often the largest assets of the divorcing parties. Recent tax legislation substantially changes the tax treatment of gain realized on the sale of a principal residence. The new rules are effective for sales or exchanges occurring after May 6, 1997, and allow qualifying taxpayers to exclude from gross income gain up to $250,000, or $500,000 for qualifying joint filers. Gain realized on the sale or exchange of a principal residence can be excluded once every two years. The property needs to be a principal residence. An issue can arise when real property is used partly as a residence and partly for business, because both an ownership and use requirement exist. The house must have been owned and used as a principal residence for two of the last five years immediately preceding the sale or exchange. The use does not necessarily have to have been continuous. For married taxpayers filing a joint return in the year of sale, either spouse can meet the ownership and use test. Special rules apply to parties who are separated or divorced. If the party selling has obtained ownership of the residence through a transaction qualifying under I.R.C. § 1041, the ownership period is aggregated. Additionally, if one of the spouses is granted use of the house under a decree of divorce or separate maintenance, the period of use by the non-owning party of the principal residence is imputed to the spouse who owns the property. If one of the spouses abandons the matrimonial home, the time period during which the other spouse occupies the residence prior to the execution of a divorce instrument will not be counted toward meeting the time period for using the residence as a matrimonial home by the spouse who abandoned the matrimonial home. Thus, care needs to be exercised in cases where one of the parties abandons the matrimonial home and the other party continues to live in the residence for a substantial period of time prior to formal divorce proceedings.
The amount of the standard exclusion is $250,000, but certain married taxpayers can exclude up to $500,000 if (1) the spouses file a joint return in the year of sale, (2) either spouse meets the ownership requirements, (3) both spouses meet the use requirements, and (4) neither spouse has sold another residence within the prior two years.
Two Out of Five Ain't Bad
As a planning tool, consider the following: Spouses can shelter $500,000 by filing a joint tax return as long as one of the spouses owned the house for at least two of the five years preceding the sale and the house was used by both spouses as their principal residence for at least two of the five years preceding the sale. When the house is jointly owned or is community property, the spouses can file separate returns and each exclude $250,000 of the respective share of gain realized, as long as both parties pass the two-out-of-five-year ownership and use test.If the parties are former spouses, the following might apply: A former spouse receiving the house can aggregate, for the two-out-of-five-year ownership period, the ownership period of the transferor spouse. In order to increase the $250,000 exclusion to $500,000, the transferee former spouse can remarry and live in the house for two years before selling, and the larger exclusion will be applicable.
If the former spouses continue to co-own the residence for a number of years-for example, to provide a home for the children-and only one of the former spouses occupies the residence, the non-residing spouse in three years will have failed the two-out-of-five-year use test. The non-residing spouse must make sure that the divorce or separation instrument allows the former spouse to occupy the house in such a manner that the non-occupying former spouse gets credit for use towards the exclusion.
John J. Weiler is a senior partner in the New Orleans tax specialty firm of Weiler & Rees. He is board certified in Louisiana as a tax attorney and an estate planning specialist.