789 / Do transfers of property between spouses, or between former spouses incident to a divorce, result in taxable gains and losses?

This nonrecognition rule means that the transfer of property between divorcing spouses in exchange for the release of marital claims generally will not result in a gain or loss to the transferor spouse. A transfer is considered made “incident to a divorce” if it is made within one year after the date the marriage ceases, or if the transfer is related to the cessation of the marriage.³ A transfer is related to the cessation of a marriage if: (1) the transfer is pursuant to a divorce or separation instrument; and (2) the transfer occurs not more than six years after the date on which the marriage ceases.

Transfers not meeting the above two requirements are presumed not to be related to the cessation of a marriage, but taxpayers may overcome this presumption by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage. Taxpayers may show this by establishing that certain factors, such as legal impediments, hampered an earlier transfer of the property, provided that the transfer occurs promptly after any cause for the delay is resolved.⁴ For example,
a transfer of a business interest between former spouses that did not occur within six years of their divorce was considered incident to divorce since there existed a legal dispute between the former spouses concerning the value of the property and the terms of payment.⁵ See also Young v. Commissioner,⁶ in which a transfer within four years of the divorce was considered to have been made “incident to divorce,” thus making all gain on the transaction taxable to the transferee spouse.⁷

While the nonrecognition rule shields from recognition gain that would ordinarily be recognized on a sale or exchange of property, it does not shield from recognition interest income that is ordinarily recognized upon the assignment of that property to another taxpayer. Where a taxpayer transferred Series E and EE bonds to his spouse pursuant to a divorce settlement, the IRS determined that he must include as income the unrecognized interest accrued from the date of original issuance to the date of transfer. This income does not constitute gain, for purposes of the nonrecognition rule, but rather is interest income subject to the general rule that deferred, accrued interest on United States savings bonds be included as income in the year of transfer. The spouse’s basis in the bonds became the amount of the taxpayer’s basis plus the amount of deferred, accrued interest recognized by him upon transfer.⁸

The Tax Court held that the nonrecognition provided in IRC Section 1041 does not apply to interest income received by a spouse through monthly installment payments made on a promissory note executed to effect a division of marital property. The court reasoned that the principal and interest portions of an installment payment constitute two distinct items that give rise to separate federal income tax consequences. Thus, the portions of the monthly installment payments that were allocated to principal under the terms of the separation agreement were not taxable to the payee spouse, but the portions allocated to interest were taxable to her.⁹

Where property is transferred by trust, either between spouses, or between former spouses incident to divorce, gain will be recognized by the transferor to the extent that the sum of the liabilities assumed by the transferee plus the amount of liabilities to which the property is subject exceeds the total of the adjusted basis of all the property transferred. The transferee’s basis will be adjusted to reflect the amount of gain recognized by the transferor.¹⁰

In addition, the transfer of an installment obligation generally will not trigger gain, and transfer of investment credit property will not result in recapture if the property continues to be used in a trade or business.¹¹ However, where installment obligations are transferred in trust, gain will be recognized by the transferor to the extent that the obligation’s fair market value at the time of transfer exceeds its basis.¹²

The transfer of an interest in an individual retirement account or an individual retirement annuity to a spouse pursuant to a divorce or separation instrument will not be considered a taxable event. The individual retirement account will be treated as owned by the transferee at the time of transfer, and the transfer does not result in taxable gain or loss.¹³ However, the statutory requirements for this nonrecognition treatment must be strictly observed.¹⁴ The Service privately ruled that a husband’s payment of a lump-sum in exchange for his ex-wife’s community property interest in a nonqualified deferred compensation plan payable to the husband by his employer constituted nontaxable transfers between former spouses related to the cessation of their marriage. Furthermore, the assignment of income doctrine did not cause the wife to be taxed when her former husband received payment of that deferred compensation from his employer.¹⁵

The IRS has determined that the division of one charitable remainder unitrust (CRUT – see Q 8088) into two CRUTs to effectuate a property settlement in a divorce proceeding does not cause the original or resultant trusts to fail to qualify under IRC Section 664.¹⁶

The Service has ruled that when nonstatutory stock options and nonqualified deferred compensation are transferred incident to divorce, the nonstatutory stock options will be taxed at the time that the receiving spouse exercises the options, and the deferred compensation will be taxed when paid (or made available) to the receiving spouse.¹⁷ In addition, the Service has ruled that the transfer of interests in nonstatutory stock options and nonqualified deferred compensation from the employee spouse to the nonemployee spouse incident to divorce does not result in a payment of wages for FICA and FUTA tax purposes. The nonstatutory stock options are subject to FICA and FUTA taxes at the time of exercise by the nonemployee spouse to the same extent as if the options had been retained and exercised by the employee spouse. The nonqualified deferred compensation also remains subject to FICA and FUTA taxes to the same extent as if the rights to the compensation had been retained by the employee spouse. To the extent FICA and FUTA taxation apply, the wages are those of the employee spouse. The employee portion of the FICA taxes is deducted from the wages as, and when, the wages are taken into account for FICA tax purposes. The employee portion of the FICA taxes is deducted from the payment to the nonemployee spouse. The revenue ruling also contains reporting requirements with respect to such transferred interests.¹⁸

Where a husband transferred his 25 percent interest in real property to his former wife, in consideration for a settlement agreement that provided to her a credit against the $500,000 equalizing money judgment that he owed to her, and the former wife then sold her undivided 50 percent interest in the same property to an unrelated third party, the Tax Court held as follows: (1) the first transaction, which occurred within one year after the date of the divorce, took place incident to divorce and, therefore, qualified for nonrecognition treatment under IRC Section 1041(a)(2); and (2) the second transaction did not fall within IRC Section 1041(a)(2) because it was not a transfer to, or on behalf of, the taxpayer’s former husband and incident to divorce. The Tax Court reasoned that the wife’s sale of the property to the unrelated third party did not satisfy any legal obligation or liability that the taxpayer’s former husband owed to her (or anyone else). Accordingly, the Tax Court concluded that the wife would have to recognize gain resulting from the sale in her interest in the property.¹⁹

Transfers occurring before July 19, 1984 were subject to substantially different rules, which sometimes resulted in a taxable gain to the transferor spouse. For application of the gift tax to property settlements, see Q 892.