DIVORCE LAWYER FOLSOM | TAX MARITAL ASSETS

The tax consequences of dividing marital property in a divorce can be complicated.   Internal Revenue Code (IRC) Section 1041 provides that no gain or loss is recognized on the transfer of property between spouses. Transfers that qualify under Section 1041 do not have to recognize gain or loss for income tax purposes, and the transferee spouse receives carryover basis like a gift. Section 1041’s nonrecognition rule applies to transfers between married partners who are not contemplating divorce and, in addition, extends to transfers that are incident to divorce. “Incident to divorce” is defined in Section 1041(c) as a transfer that occurs within one year after the date on which the marriage ceases or that is related to the cessation of the marriage. Temp. Regs. Section 1.1041-1T further defines the term “related to cessation of the marriage” to be a transfer pursuant to a divorce or separation instrument, if the transfer occurs within six years after the date on which the marriage ceases. However keep in mind Section 1041’s nonrecognition rule does not apply to transfers made to nonresident alien spouses or to transfers in trust where liability exceeds basis.

Considering Section 1041’s nonrecognition rule as well as the unlimited marital deduction for federal estate and gift tax purposes allowed under Section 2523 for gifts of cash and property to a spouse, most property transfers in divorce will likely be nontaxable transfers.

With the presumption that any transfer within six years from the date of divorce, assuming it is under a divorce or separation agreement is treated as nontaxable under Section 1041.  In IRS Letter Ruling 8833018, this became evident when the husband was awarded a right of first refusal to acquire the family home that was awarded to the wife. This right of first refusal was exercised within the six-year time frame, and the husband “purchased” the home from his former spouse. The IRS indicated that it was not a purchase and sale but a nontaxable transfer under Section 1041. This resulted in the wife’s receiving nontaxable cash from the “sale” of the home and the husband’s receiving the home with the wife’s cost basis which was lower the purchase price, likely not the result he was hoping for.

Being able to qualify for nonrecognition of income under Section 1041 at the time of a divorce makes the division of assets much easier but leads to certain longer-term tax consequences. Since the assets have carryover basis, the potential tax liability has only been deferred. Looking at the potential tax liability of all the assets that are being divided from the marital estate can help to make the asset division more equitable as well as eliminate potential surprises for the parties later.

Since any asset received will have carryover basis, it is important to obtain the basis information as soon as possible. Temp. Regs. Section 1.1041-1T indicates that the transferor of property under Section 1041 must provide the transferee with sufficient records to determine the cost basis, holding period, and other tax information relating to the property at the time of the transfer. An adviser should recommend that a transferee spouse try to obtain this before the divorce is finalized or require it be provided in the future in the final settlement agreement to ensure compliance. 

By having the cost basis prior to the final dissolution, your tax advisers will be able to estimate any potential tax liability of the asset clients are receiving as well as have the information for reporting any future sale.

The principal residence is a typical asset that is discussed and awarded during a divorce. IRC Section 121 allows joint filers to exclude up to $500,000 of gain on the sale of a residence, and individual filers can exclude up to $250,000 of gain. This can provide a tax planning opportunity for some divorcing couples. For joint filers to qualify for the exclusion, one party needs to have owned the residence, and both parties need to have used the residence as their principal residence for a total of any two out of the last five consecutive years.

Section 121 provides very favorable treatment for parties in divorce to assist them in meeting the ownership and use tests. First, to help meet the ownership test, Section 121(d)(3)(A) allows the residence transfer from one spouse to the other spouse to include the holding period. This would allow the receiving spouse to count any ownership time of the transferor spouse as the receiving spouse’s own. Section 121(d) (3)(B) helps the parties meet the use test by allowing an individual to be treated as using property during any period of ownership while their spouse or former spouse is granted use of the property under a divorce or separation instrument. So, if one party is given temporary use of the home in a divorce instrument, the other party can count that use time as their own. Note that voluntarily moving out will not count, as it needs to be part of the agreement.

Retirement plans come in many forms and are also a common asset to be divided in a divorce. “Qualified” plans include pension and profit-sharing plans, such as defined benefit plans, Section 401(k) plans, and Section 403(b) plans. These employer-provided plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA), which provides that these types of plans cannot be assigned from one spouse to the other without a qualified domestic relations order (QDRO). The requirements of a QDRO are listed in Section 414(p), and failure to follow them can have adverse tax consequences. Once the divorce court produces the order to assign some or all of the retirement account to the spouse (alternate payee), and the qualified plan administrator has determined it meets the conditions of Section 414(p) and signs the document, you have a QDRO. The retirement account will now be divided between the parties as provided in the QDRO.

An individual retirement account (IRA) is not covered under ERISA and does not need a QDRO to divide. This is also true for Roth IRAs, rollover IRAs, and nonqualified retirement and deferred compensation plans, as well as a few others. These accounts can be divided by including the instruction in the settlement agreement. These instructions constitute a domestic relations order, not a “qualified” domestic relations order in the same way that property divisions, alimony, and other instructions are recorded in an agreement.

One planning note is that a retirement account being divided via a QDRO has an opportunity to distribute funds out of the plan without having to pay the 10% early-distribution penalty. The 10% penalty normally applies if the spouse receiving the retirement distribution is under 59½ years old. Therefore, the QDRO distribution will be taxable as ordinary income but without the 10% penalty regardless of the spouse’s age. This can be a good way to generate some liquidity in a divorce with limited other assets. This distribution must be part of the QDRO instructions and is not available for IRAs, as they are not divided with a QDRO.

If you have any questions call Shintia Z. Riva, Esquire at 610-521-0604. Shintia specializes in family law at the Law Offices of Spadea & Associates, LLC.   

Divorcing couples may agree on how to divide their marital property themselves. In Pennsylvania, spouses can enter into a “property settlement agreement” (PSA) that memorializes their agreed-upon terms. Couples then submit their PSA to the court, so it can be incorporated into their final divorce decree.

If spouses can’t agree, they’ll end up in court, where a judge will decide. If spouses have a valid prenuptial agreement that addresses the division of property in the event of divorce, courts will follow the terms of the prenuptial agreement.

If there is marital property not covered by the prenuptial agreement, or if there is no valid prenuptial agreement, the court will divide marital property by “equitable distribution.” This means the court will order a division it believes is equitable or fair to both parties but not necessarily equal.

Pennsylvania courts consider several factors when determining equitable distribution, including:

• The length of the marriage;
• Whether either spouse has been married previously;
• Each spouse’s age, health, education, amount of income, and sources of income including disability, retirement, insurance or other benefits;
• Each spouse’s vocational skills and ability to be employed;
• The assets, debts, and needs of each spouse;
• Any contributions by one spouse to the other’s education, training, or earning ability. For example, if one spouse provided financial support or cared for the couple’s children so the other spouse could obtain an education;
• The future ability of each spouse to earn income and obtain assets;
• Each spouse’s contribution to the acquisition of marital assets or to preserving or increasing the value of marital assets (including contributions as a homemaker);
• Any reduction in the value of marital assets caused by either spouse;
• The amount or value of non-marital assets owned by each spouse;
• The standard of living the couple enjoyed during the marriage;
• The financial impact any proposed property division will have on each spouse such as the tax implications, and the expense of sale/transfer/liquidation of property; and
• Whether either spouse will be the custodian of any dependent children under the age of 18.

In Pennsylvania, courts do not consider marital misconduct, such as adultery, when dividing property, unless the misconduct had a financial impact on marital property. For example, if one spouse emptied a marital bank account buying gifts for a lover during the marriage and without the other spouse’s consent, a court may reduce the percentage the “offending” spouse gets from the marital estate to compensate for the unauthorized spending.

Debts must be divided in divorce as well. You’ll need to identify, characterize, and value all debts. Be sure to make a list, and consider all credit card debts, loans, mortgages, promissory notes, and liens.

Debts are characterized and valued similar to assets, but there are some differences. Debts incurred during marriage are generally considered marital debts, unless a spouse can show that it’s reasonable to assign the debt exclusively to the other spouse.

Debts incurred before marriage are generally “separate” and assigned to the spouse who incurred them, unless the couple jointly incurred the debt before marriage. In addition, if a debt was incurred before marriage for a marital purpose e.g., loan for wedding costs, there is a chance a court would characterize it as marital. Thus, the balance of premarital debts is generally irrelevant, except to show the amount of indebtedness one spouse has. Debts incurred after separation are treated in the same manner.

If you have any questions about Pennsylvania marital property or debts call Gregory J. Spadea at 610-521-0604 of the Law Offices of Spadea & Associates, LLC.