Dividing up assets when a marriage ends: Tax implications

Editor: Theodore J. Sarenski, CPA/PFS

An often-cited belief is that 50% of marriages now end in divorce. Regardless of whether this statistic is accurate (for first marriages, the divorce rate more likely peaked at around 40% in the United States around 1980 and declined to about 30% by the early 21st century), most CPAs have observed the impact that divorce can have in the lives of friends and clients (or in their own lives). A tax practitioner can greatly help people in divorce by reducing the overall stress of the divorce process and providing the clarity they need to make good financial decisions for their future.

When dividing assets in divorce, the tax considerations can be straightforward in simple situations but can become complex very quickly when the assets are larger and more diverse. This column focuses on the tax implications of dividing marital property.

Beginning with the basics, Sec. 1041 provides that no gain or loss is recognized on the transfer of property between spouses. This Code section, which was introduced in the Deficit Reduction Act of 1984, P.L. 98-369, changed the treatment of transfers between spouses, which previously were treated like sales (referred to as the Davis rule, after Davis, 370 U.S. 65 (1962)).

Transfers that qualify under Sec. 1041 do not have to recognize gain or loss for income tax purposes, and the transferee spouse receives carryover basis like a gift. Sec. 1041’s nonrecognition rule applies to transfers between married partners who are not contemplating divorce and, in addition, extends to transfers that are incident to divorce. “Incident to divorce” is defined in Sec. 1041(c) as a transfer that occurs within one year after the date on which the marriage ceases or that is related to the cessation of the marriage. Temp. Regs. Sec. 1.1041-1T further defines the term “related to cessation of the marriage” to be a transfer pursuant to a divorce or separation instrument, if the transfer occurs within six years after the date on which the marriage ceases. (Caution: Sec. 1041’s nonrecognition rule does not apply to transfers made to nonresident alien spouses or to transfers in trust where liability exceeds basis — Secs. 1041(d) and (e)).

Considering Sec. 1041’s nonrecognition rule as well as the unlimited marital deduction for federal estate and gift tax purposes allowed under Sec. 2523 for gifts of cash and property to a spouse, most property transfers in divorce will likely be nontaxable transfers.

With the presumption that any transfer within six years from the date of divorce (assuming it is under a divorce or separation instrument) is treated as nontaxable under Sec. 1041, it is prudent to be mindful of any transaction during this six-year time frame. In IRS Letter Ruling 8833018, this became evident when the husband was awarded a right of first refusal to acquire the family home that was awarded to the wife. This right of first refusal was exercised within the six-year time frame, and the husband “purchased” the home from his former spouse. The IRS indicated that it was not a purchase and sale but a nontaxable transfer under Sec. 1041. This resulted in the wife’s receiving nontaxable cash from the “sale” of the home and the husband’s receiving the home with the wife’s basis — likely not the result he was hoping for.

Being able to qualify for nonrecognition of income under Sec. 1041 at the time of a divorce makes the division of assets much easier but leads to certain longer-term tax consequences. Since the assets have carryover basis, the potential tax liability has only been deferred. Looking at the potential tax liability of all the assets that are being divided from the marital community can help to make the asset division more equitable as well as eliminate potential surprises for the parties later.

Since any asset received will have carryover basis, it is important to obtain the basis information as soon as possible. Temp. Regs. Sec. 1.1041-1T indicates that the transferor of property under Sec. 1041 must provide the transferee with sufficient records to determine the cost basis, holding period, and other tax information relating to the property at the time of the transfer. An adviser should recommend that a transferee spouse try to obtain this before the divorce is finalized, as attempting to obtain it later may prove to be more difficult. If this is not possible, an adviser should recommend to the transferee spouse to consider including this requirement in the final documents to allow for enforcement, if necessary, as the regulations provide no penalty for noncompliance. By having the cost basis prior to the final dissolution, advisers will be able to estimate any potential tax liability of the asset clients are receiving as well as have the information for reporting any future sale.

Planning for the principal residence

The principal residence is a typical asset that is discussed and awarded during a divorce. Sec. 121 allows joint filers to exclude up to $500,000 of gain on the sale of a residence, and individual filers can exclude up to $250,000 of gain. This can provide a tax planning opportunity for some divorcing couples. For joint filers to qualify for the exclusion, one party needs to have owned the residence, and both parties need to have used the residence as their principal residence for a total of two out of the last five years.

Sec. 121 provides very favorable treatment for parties in divorce to assist them in meeting the ownership and use tests. First, to help meet the ownership test, Sec. 121(d)(3)(A) allows the residence transfer from one spouse to the other spouse to include the holding period. This would allow the receiving spouse to count any ownership time of the transferor spouse as the receiving spouse’s own. Sec. 121(d) (3)(B) helps the parties meet the use test by allowing an individual to be treated as using property during any period of ownership while their spouse or former spouse is granted use of the property under a divorce or separation instrument. So, if one party is given temporary use of the home in a divorce instrument, the other party can count that use time as their own. Note that voluntarily moving out will not count, as it needs to be part of the agreement. In summary, Sec. 121 provides many opportunities to minimize tax on a personal residence for divorcing couples, and this can extend to planning for couples with multiple residences.

Dividing retirement plans

Retirement plans come in many forms and are also a common asset to be discussed and divided in a divorce. “Qualified” plans include pension and profit-sharing plans, such as defined benefit plans, Sec. 401(k) plans, and Sec. 403(b) plans. These employer-provided plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA), P.L. 93-406, as amended, which provides that these types of plans cannot be assigned from one spouse to the other without a qualified domestic relations order (QDRO). The requirements of a QDRO are listed in Sec. 414(p), and failure to follow them can have adverse tax consequences. Once the divorce court produces the order to assign some or all of the retirement account to the spouse (alternate payee), and the qualified plan administrator has determined it meets the conditions of Sec. 414(p) and signs the document, you have a QDRO. The retirement account will now be divided between the parties as provided in the QDRO.

An individual retirement account (IRA) is not covered under ERISA and does not need a QDRO to divide. This is also true for Roth IRAs, rollover IRAs, and nonqualified retirement and deferred compensation plans, as well as a few others. These accounts can be divided by including the instruction in the settlement agreement. These instructions constitute a domestic relations order (not a “qualified” domestic relations order) in the same way that property divisions, alimony, and other instructions are recorded in an agreement.

One planning note is that a retirement account being divided via a QDRO has an opportunity to distribute funds out of the plan without having to pay the 10% early-distribution penalty. The distribution will be taxable as ordinary income but without the penalty. This can be a good way to generate some liquidity in a dissolution with limited other assets. This distribution must be part of the QDRO instructions and is not available for IRAs, as they are not divided with a QDRO.

Other assets and activities

Higher-net-worth divorcing couples may have other assets, including businesses, rental real estate, and additional personal assets that can be divided. Each of these assets should be reviewed for tax issues and opportunities. When dividing passive activities, advisers should also consider how the income or loss from the asset will be treated for tax purposes in the future. While the couple are still married, Sec. 469(h)(5) provides that the participation of one spouse in a passive activity will allow both spouses to be treated as participating. After the divorce, each spouse will need to meet the material-participation test on their own for any activity they own. A couple and their advisers would want to avoid turning a formerly nonpassive activity into a passive activity by virtue of transferring it to a spouse who does not meet the materialparticipation rules.

It is not uncommon for a passive real estate activity to have suspended losses that were not allowed in prior years. Typically, a disposition of a passive activity in a fully taxable transaction allows the deduction of these suspended losses (Sec. 469(g)(1)). However, in divorce, a distribution under Sec. 1041 is treated as a gift and not a disposition of the activity. As such, the suspended losses are added to the basis and are not allowed as a future deduction. (Community property states would add 50% to the basis, as only 50% was a gift.)

Toward an equitable division

Since different assets have different tax treatments, it is unlikely that a complex divorce can ever result in assets being divided perfectly “equally.” This is especially true as the parties will typically have certain assets that they prefer to keep, regardless of the tax treatment. A good practice is to group assets into similar “buckets” and then try to equally divide the buckets — retirement accounts in one bucket, passive activities in another, cash and investments in yet another, and so on. Then, dividing these buckets as equally as possible can help to get closer to an equitable distribution.

Also, it should be kept in mind that the goal in dividing the assets is to provide each party with the best opportunity for financial success in the future. Advisers working with one party in the divorce will want to factor in their personal goals and compare them with the cash flow that they would be receiving from the assets awarded to them in the divorce. Since living on divided assets will be different from living on the shared assets as the couple did in the past, they will likely need to make some adjustments to their personal lifestyle. Preparing a cash flow projection that includes the tax planning from the asset division can provide them with the confidence to make financial decisions about their future, and it will help them get started on their new personal and financial lives.

Contributors

David Stolz, CPA/PFS, CDFA, CFP, is with Stolz & Associates in Tacoma, Wash., and the author of Women, Divorce and Money: Taking Control of Your Finances and Your Future. Theodore J. Sarenski, CPA/PFS, CFP, is a wealth manager at Capital One/ United Income in Syracuse, N.Y. Mr. Sarenski is chairman of the AICPA Advanced Personal Financial Planning Conference. He is also a past chairman of the AICPA Personal Financial Planning Executive Committee and a former member of the Tax Literacy Commission. For more information about this column, contact thetaxadviser@aicpa.org.