When couples divorce, their property is generally split equally between them. But often, the couple has a balance sheet that doesn’t easily divide. If one spouse wants to keep more assets than the other, and has no source of funds to equalize the division, he will give his spouse a promissory for the difference. The note is for the amount of the amount needed to equalize the division of property, and usually provides for payments of principal plus interest at a reasonable rate.

A recent court case clearly has established that the interest paid to the ex-spouse is taxable to her, even though the principal on the note is exempt from tax as a transfer incident to divorce (Gibbs, TC Memo 1997-196). So if the recipient has to pay tax on the interest, the paying spouse should receive a corresponding deduction on his income tax return, right? Not necessarily. Until recently, the IRS has ruled that divorce-related interest is non-deductible personal interest, and has disallowed any deduction for it.

Several court cases have sided with the taxpayer and against the IRS. John Seymour gave his wife Katherine a promissory note for $625,000 in exchange for her interest in their business and marital residence. The note was payable over ten years with 10% interest per year. The note was secured by a mortgage on the residence.

The IRS disallowed all the interest, but the Tax Court ruled that the interest should be allocated among all the assets John received from Katherine in the divorce. Thus, a portion of the interest was deductible as home mortgage interest, and much of the rest was deductible as investment interest on the acquisition of the business and business real estate. (Seymour, 109 TC No 14 (1997).

In another case, Ronald Armacost gave his wife Linda a 20-year promissory note for $250,000, payable with interest at 10%. The note was secured by the properties Ronald received from Linda. Once again, the IRS said that the interest was not deductible by Ronald, since divorce has a personal rather than a business purpose. The Tax Court, following Seymour, said that the IRS was right to disallow the deduction only to the extent the note was to acquire Linda’s non-investment property. But the Tax Court determined that most of the note was given to acquire investment property, so it allowed Ronald a deduction for most of the interest as investment interest. (Armacost, TC Memo 1998-150).

Legal fees paid in divorce have also been the subject of contention between taxpayers and the IRS. Legal expenses involving personal matters are not deductible, but legal expenses related to the taxpayer’s business are deductible. When Mr. Poulos, who operated video game arcades, entered the hospital with heart problems, his wife took the offensive. She and her boyfriend took possession of the businesses, fired the employees and stripped the arcades of cash and equipment. Once out of the hospital, Mr. Poulos hired a law firm to file for divorce and to recover his business assets. The IRS disallowed the deduction Mr. Poulos took for legal fees, saying that they were connected with the divorce and therefore not deductible. But the Tax Court ruled that the fees were deductible to the extent they were incurred to protect the business activities. (Liberty Vending, Inc., TC Memo 1998-177).