Structuring Tax-Free Property Settlements Between Divorcing Spouses

By: Walter Reed
: October 31, 2016

The transfer of property between divorcing spouses should be a tax-free event. However, like most tax transactions, there are pitfalls lurking out there waiting to trip up the unwary.

When dividing property pursuant to a property settlement agreement, all parties must do their part to ensure the best possible result is achieved for both sides – which is a tax-free transfer of the property. 

Usually, in a non-gifting transaction, the sale or transfer of appreciated property results in the recognition of gain to the seller to the extent the sales price exceeds the adjusted cost (basis) of that property. For example, John owns a piece of real estate that he bought for $10,000 and made no subsequent improvements to the property. In 2016, John sells the property to Jane for $18,000 (the fair market value). On his 2016 tax return John will report a gain on the sale of the real estate in the amount of $8,000.

A similar result happens if there is an exchange of property instead of a sale. In the above example, instead of selling the real estate to Jane, John exchanges the land for a vehicle owned by Jane that also has a fair market value of $18,000. In this example, John is still required to recognize a gain of $8,000 ($18,000 value received – 10,000 basis).

Fortunately, the Internal Revenue Code provides an exception to the gain recognition rules set forth in the above examples if the transactions are structured properly.

Transfers of Property That Are Not Recognized as a Gain or Loss 

The general rule of Section 1041 of the Internal Revenue Code (the “Code”) states that no gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of) (1) a spouse, or (2) a former spouse, but only if the transfer is incident to a divorce. Because of the existence of Section 1041 in the Code, the gain that would normally be recognized when transferring appreciated property between individuals in a non-gifting situation does not become an issue for divorcing couples. The challenge in this situation is to make sure the transactions are structured so that they are considered a “transfer incident to divorce”, which begs the question – what qualifies as a transfer incident to divorce? To find the answer to this question you must dig a little deeper in Section 1041.

What Qualifies as a Transfer Incident to a Divorce 

Section 1041(c) of the Code states that a transfer of property is considered incident to a divorce if such transfer (1) occurs within one year after the date on which the marriage ceases, or (2) is related to the cessation of marriage. This second point gives practitioners a wide latitude in properly structuring property transfer transactions.

Many practitioners believe the window of opportunity to obtain tax-free property transfers between divorcing spouses is limited to one year after the marriage ceases. However, if you review the Treasury Regulations associated with Section 1041, you will find that any transfer of property that is made pursuant to a divorce or separation agreement and occurs within six years after the date the marriage ceases is presumed to be related to the cessation of the marriage.

You may even be able to achieve the tax-free treatment of Section 1041 for property transfers that occur longer than the six-year period mentioned in the Treasury Regulations. However, a transfer that occurs after the six-year period must be supported by evidence showing the transfer is to affect the division of property owned by the former spouses as of the date the marriage ended. There is not an automatic tax-free presumption as there would be if the transfer occurred within the six-year period.

A recent court case decided by the U.S. Tax Court even held that property transferred subject to a second property settlement could be transferred tax-free under Section 1041 of the Code (Belot v. Commissioner).

In summary, sales or transfers of appreciated property between two parties generally results in gain recognition to the seller of the property. However, divorcing spouses, by virtue of Code Section 1041 of the Code, can transfer property between themselves on a tax-free basis if property structured through a property settlement agreement.