Divorce Tax Implications

According to IRC section 1041, no gain or loss is recognized on a transfer of property between spouses in a divorce. However, there are circumstances in which a transfer of property to a third party on behalf of a spouse (or former spouse) also qualifies for nonrecognition treatment.

A transfer is considered to be “on behalf of” a spouse if it satisfies that spouse’s obligation or liability. In a situation where a property transfer to a third party is required by a divorce or separation agreement, the transfer is treated as if it had been made to the nontransferring spouse and, then, transferred by that spouse to the third party (regulations section 1.104-1T(c), Q & A 9).

In United States v . Craven, DC GA 2-18-99, 83 AFTR 99-526, a wife sued her husband for divorce and equitable distribution of their marital property. The settlement agreement required the couple’s closely held corporation (third party) to redeem the wife’s stock. The agreement also required the husband to guarantee the corporation’s payment to the wife.

When filing her tax return, the wife argued that because the stock redemption was pursuant to her divorce agreement it qualified for nonrecognition treatment. The IRS disagreed. It claimed that the wife was liable for the capital gains tax related to the redemption of her stock.

The court found that state law required the husband to equitably divide the marital property. It then concluded that the stock redemption satisfied the husband’s marital obligations under the settlement agreement. In finding for the wife, the court relied on United States v . Arnes, 981 F.2d 456 (1992), where the Ninth Circuit Court of Appeals had held that a stock redemption required by a divorce agreement warranted nonrecognition treatment because the stock transfer had relieved her former husband of a debt that he owed directly to her.

In another recent case, United States v . Ingham, CA-9 (2-11-99), a wife sold some real estate to a third party and, as required by her divorce decree, gave the proceeds to her husband. In this situation, according to the court, the sale was not a transfer “on behalf of” her former spouse, because the sale did not relieve him of any obligation or liability that he owed to her or to a third party. The sale merely allowed her to pay off a debt that she already owed her former husband under their property settlement.

Observation . There is no provision in the tax code similar to section 1041 for transfers of property between unmarried individuals who live together and later separate. But, in Commissioner v . Reynolds, TC Memo 1999-62, a court ruling in a situation in which a couple lived together and then separated provides some guidance. Violet and Gregg lived together for 24 years. Gregg told Violet that he would provide for her financially. She took care of the couple’s house and boat. She also acted as hostess for their parties and as Gregg’s nurse when he was ill.

Gregg moved out and broke off the relationship. He sued Violet and asked for a judgment that she had no interest in the property purchased during their relationship. Violet asserted that she had an equitable interest in the property. She settled her claim for $153,500, but did not report this as income on her tax return. She argued it was a gift. The IRS claimed that it was taxable as compensation for past services.

The Tax Court sided with Violet and found that Gregg had paid the disputed amount to Violet in surrender of her rights in the property that he had given to her as a gift during their relationship.

— Michael Lynch, CPA, Esq., professor of tax accounting at Bryant College, Springfield, Rhode Island.