Planning during the process of divorce. (Federal Taxation)by Deutsch, Steven
Even though the transfer of any property between spouses or between former spouses incident to a post-July 18, 1984, divorce is a non- taxable event under IRC Sec. 1041, there are important tax considerations to be addressed. The largest asset in most marital estates is the marital residence. The Bask Rules
The tax basis of a marital residence transferred incident to a divorce is its carryover basis irrespective of the fair market value of the property at the time of the transfer or the consideration paid. The liability for income tax on any gain is deferred to the year gain is realized upon the taxable sale to a third party. The inherent unrealized tax liability must be considered in any proposed "Equitable Distribution." Any transfer occurring between spouses as a result of divorce or during the one year period following the date the marriage ceased is an unrebuttable Sec. 1041 non-taxable event. This is regardless of the parties' intentions to cause an arms length taxable sale. During a six-year period following the cessation of the marriage, any transfer between former spouses carries a presumption that the transfer is incident to the divorce. Likewise, any transfer more than six years after the divorce decree is presumed not to be subject to Sec. 1041. Either presumption can be rebutted by the facts and circumstances.
It is not unusual, incident to the instruments of the divorce, for the final division of the former marital residence to extend to or beyond the emancipation of the youngest child with the custodial parent obtaining exclusive occupancy.
Transfer of the marital residence incident to a pre-July 19, 1984, divorce is treated as though the transferor spouse or former spouse sold his or her ownership interest at the then fair market value of the property. The transferor spouse is liable for the tax on the gain. The gain is reportable on transferor's tax return for the year the property was transferred. The recipient spouse receives a stepped-up basis to the extent of the fair market value on the portion of the property transferred.
An irrevocable election to apply Sec. 1041 treatment on transfers made after july 18, 1984, pursuant to a pre- July 19, 1984, agreement can be made, provided that both spouses or former spouses concur. The election must be attached to the Form 1040 for the year in which the first transfer occurs. Determination of a house as principal residence qualifies gain on the sale of the house and deductions relating to that house for special preferable tax treatment. The marital residence can continue to be the "principal residence," even though a spouse moved out during the marital dispute. What is required is that the spouse demonstrate an intent to return to the same house and establish no other principal residence." Establishing the marital residence as the "principal residence" becomes considerably more complex for the spouse living elsewhere. The terms of agreements and orders of the Court must be considered in order to determine principal residence. Proper planning can provide significant tax savings. Many opportunities are available only during special windows of opportunity. Exclusion on Deferral of Gain
Properly timed application of IRC Secs. 121 and 1034 can exclude $250,000 of gain on the sale of a marital residence instead of just $125,000, with a rollover of the balance of the otherwise taxable gain into two houses, instead of just one. The $125,000 Sec. 121 exclusion and the Sec. 1034 sale/replacement deferral are not mutually exclusive; they can be combined. Double benefits occur by the interplay of Secs. 121, 1034 and 1041 when the appropriate facts are present.
For example, if both parties, age 55 or older have jointly owned and lived in the principal residence for three of the last five years, then the Sec. 121 tests for residence and ownership can be met separately, during different three year periods, provided both tests are satisfied for each taxpayer spouse during the five-year period immediately proceeding the sale (Rev. Rul. 80-172).
The Sec. 1034 deferral or tax-free rollover applies separately to each taxpayer spouse after the divorce, whereas it applies jointly while the taxpayers are married. Former spouses can each utilize the tax free rollover provisions of Sec. 1034, provided each qualify otherwise.
The taint of Sec. 121 applies to both spouses if the residence is sold during marriage, without regard to ownership. The taint occurs at the date of sale. A spouse is prohibited from electing Sec. 121 if his or her spouse previously made a Sec. 121 election. The untainted spouse could, in the future, make a Sec. 121 election if he or she were again single or married to another untainted spouse at the date of sale Rev. Rul. 87-104). Deductibility of Mortgage interest
Beginning in 1987, interest on a principal or second residence is deductible, while most consumer interest is non-deductible. The spouse making the mortgage payments should ensure that the interest payments qualify for the deduction. Qualified residence interest" is interest paid on housing debt secured by the taxpayer's principal residence and/ or second residence, (Sec. 163(h)). The debt is required to be secured by a perfected (recorded) security instrument. Qualified residence debt" is classified either as "acquisition debt" or "home equity loan." Acquisition debt is debt incurred for the purpose of acquiring, constructing or substantially improving the residence. Debt incurred incident to a divorce to purchase a primary residence from the other spouse or former spouse is acquisition debt for the deduction of interest on such debt provided the total debt does not exceed the lesser of the fair market value of the property or $1 million ($500,000 for a married taxpayer filing separately). The mortgagee can be a third party such as a financial institution or a former spouse. A grandfather clause excludes pre-October 14, 1987, debt from the $1 million limit. A home equity loan is any other loan secured by a qualified residence," defined as a principal or second residence. Home equity interest is deductible to the extent that the loan does not exceed the lesser of the fair market value of the property reduced by the "acquisition debt" or $100,000 ($50,000 for a married taxpayer filing separately).
Where the spouse cannot qualify the marital home as the taxpayer's principal residence, the interest paid on the debt secured by that house may qualify as residence interest on a second residence. A second residence is any dwelling unit owned and personally used by the taxpayer as a residence. Personal use includes use by a family member of the owner taxpayer, unless the family member actually pays the going rental value (Sec. 280A). Payments made on the marital residence may be deductible under more than one section of the IRC, as follows:
9 Alimony includes payments paid to a third party, such as to a mortgage, for the benefit of the payee spouse. Ownership of the property is a controlling factor in the deductibility of mortgage payments. The deductibility of mortgage payments as alimony within Sec. 71 is limited to the payee spouse's proportionate ownership (Rev. Rul. 67-420). Ownership of the property is also a requirement for the deductibility of mortgage interest. The entire mortgage payment can qualify as alimony, whereas only the interest portion of the mortgage payment can qualify for an interest deduction (assuming all the other mortgage interest rules are met).
o The former marital residence may qualify as rental investment property wherein the "passive activity" rules should be considered (Sec. 469); along with vacation home rules (Sec. 280A) and the rules for "hobby loss," (Sec. 183) (Rev. Rul. 75-14). Putting it afl Together
In situations involving the division of the marital residence during the process of divorce, it is essential to consider all the tax effects: fair market value of the property, the deductible items, the income that might be generated from the property, the income of the parties, and the timing of property transfers.
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