In a divorce proceeding, it is natural for the parties involved to want to simply get through the process as quickly as possible. However, making and acting on decisions about the division and transfer of property without thoroughly considering the potential tax implications can have serious financial consequences. When an attorney is able to identify and address these issues up front, they can potentially save their clients substantial sums of money and relieve them of a lot of frustration down the road.
Most property transfers in divorce are tax free
When one spouse transfers property to the other spouse during the term of the marriage or as the result of a divorce, such transfers are generally treated as non-taxable events for U.S. federal income and gift taxes.
However, if there is a premarital agreement that requires a transfer of property in the event of a divorce, it's recommended that the agreement also require that this provision be included in the ultimate divorce decree to ensure the transfer will be considered tax free for income and gift tax purposes.
Federal tax law provides that certain property transfers, including transfers between spouses and transfers “incident to divorce" — meaning that the transfer occurs within one year after the end of the marriage, or is otherwise related to the divorce — are income tax free. In general, transfers made within one year of a divorce are presumed to be related to the divorce.
Transfers to third parties made on behalf of one spouse may also escape income taxes under certain circumstances. For example, if the property transfer was stipulated in the divorce or separation agreement or otherwise meets IRS requirements, income taxation is not triggered.
Transfers made more than one year after the divorce must be made pursuant to a decree of divorce. Any transfer made more than six years after the divorce is finalized is presumed to be unrelated to the divorce. However, this presumption can be overcome and the tax-free treatment may be upheld if there was some valid reason for the delay.
Transferring property from one spouse's name into the other's name during a marriage is generally free of any gift tax obligations because of the unlimited gift tax deduction provided under the Internal Revenue Code.
When a property transfer is related to a divorce, there are several scenarios where the transfer will be treated as a non-taxable gift:
- The transfer is made to satisfy a written settlement agreement for a divorce occurring up to one year before and two years after the execution of the settlement agreement, provided it meets certain specific requirements1
- A court order requires the property transfer
- The property transfer is in exchange for the waiver of certain support obligations
- The transfer qualifies for the annual gift tax exclusion under federal tax law ($15,000 in 2018)
- The lifetime gift tax exclusion amount covers the transfer ($11.18 million per person in 2018)
- The transfer is deemed a direct payment for educational or medical expenses
The benefit of intentionally avoiding tax-free transfers
Although it sounds counterintuitive, there are certain situations where it may make sense to forego the tax-free treatment that the law affords divorcing spouses for property transfers, and instead intentionally create a taxable event by structuring the transaction as a "true sale" rather than a gift.
Consider the following scenario: John and Sarah own a vacation property with a cost basis of $400,000. Each of them has a 50% ownership interest in the property, which is now worth $800,000.
Option 1: Transfer as Part of the Divorce Agreement
If, as part of the divorce agreement, John acquires Sarah's share and they structure the transaction as a tax-free transfer under IRS rules, John will keep the $400,000 tax basis (his $200,000 basis plus Sarah's $200,000 basis).
If John decided to sell the property at its current value of $800,000, he would realize a gain of $400,000.
The capital gains exclusion provision for real estate, where up to $250,000 in capital gains ($500,000 for a married couple filing a joint return) is exempt from capital gains taxation when certain other requirements are met, is only available for primary residences. Because the property in question is a vacation home, the capital gains exclusion will not apply.
Option 2: Transfer as a True Sale
If John and Sarah treat the transaction as a true sale more than one year after their divorce instead of as a part of the divorce agreement, the tax treatment looks somewhat different.
Sarah, selling her 50% share to John, will realize a $200,000 gain on the sale (the $400,000 value of her half of the property minus her $200,000 basis).
John's new basis in the property will be $600,000 — his original $200,000 basis plus $400,000 from the sale. If John subsequently sold the property at its current value of $800,000, he would realize a gain of $200,000, compared to the $400,000 gain that would be taxed when treating the transaction as a tax-free transfer related to the divorce. John would also need to wait one year to sell the property in order for the sale to be treated as a long-term capital gain.
For best results, work with an experienced wealth manager
Dividing up property can be a very contentious process. Divorcing spouses are sure to appreciate anything an attorney can do to help streamline and clarify the situation. However, given the complexity and sensitivity involved, attorneys can't be expected to do it all by themselves. An experienced wealth manager can assist in producing a detailed analysis that considers the various tax ramifications of any property transfers or sales, both before and after the divorce. Working together, the attorney and the wealth manager can help their divorcing clients devise a plan that allows them to enter the next chapter of their lives with confidence.