TAX CONSEQUENCES OF A DISSOLUTION OF MARRIAGE
Division of Property
Pursuant to Internal Revenue Code Section 1041, there is no gain or loss recognized on a transfer of property from an individual to a spouse or former spouse, if the transfer is “incident to the divorce.” This section applies throughout the marriage, as well as at divorce, and is unaffected by whether a non-divorce motive (or even a bona fide business purpose) is involved. It governs any transfer made after marriage even if pursuant to a premarital agreement.
The transfer of property is treated as “incident to the divorce” if the transfer “occurs within one year after the date on which the marriage ceases, or is related to the cessation of the marriage.” “Related to the cessation of the marriage” has not been defined by the Internal Revenue Service. However, the temporary regulations prescribe a rebuttable presumption that any transfer within 6 years after a divorce is “related to the cessation of the marriage,” as well as a rebuttable presumption that the transfers later than 6 years after divorce are not so related, unless a bona fide business reason exists for the delay.
The taxation or deductibility of spousal support differs between the California taxing authorities and the Federal taxing authorities. Under State and Federal law, a recipients gross income includes alimony payments and the payor may deduct these payments. In order for the payments to be taxable to the recipient and deductible to the payor under Federal law, 12 specific objective requirements are imposed. The 7 major requirements are summarized below:
- Support must be paid under a “divorce or separation instrument”–an agreement, judgment or order.
- No joint return can be filed.
- Payments must be made in cash.
- The instrument does not provide that the payments are to be non-taxable.
- There may be no payment made after the recipient’s death.
- The payments cannot be fixed for the children.
- The spouses cannot continue to reside in the same household.
In addition to the deductibility or includability of support in a given tax year, there is also a problem which we call “recomputation”. Even though the deducted support payments meet all the specifications described above, there may be a requirement that the support payments be “recaptured” under the recomputation provisions. These provisions are not a limitation on current deductibility. The rule requires payors who have previously and properly deducted payments to recapture a portion of those payments if in any calendar year during the 3 post separation years deductible payments decrease by more than $15,000.00 from any preceding payment year. Under this recomputation rule, if the spousal support payments in the first year exceed the average payments in the second and third year by more than $15,000.00, the excess amounts are recaptured in the third year by requiring the payor to include the excess in income in allowing the payee who previously included the support in income a deduction for that amount in computing adjustable gross income. A similar rule applies to the extent that the payments in the second year and the payments in the third year by more than $15,000.00.
Thus, for example, if the payor makes support of $50,000.00 in the first year and no payments in the second or third year, $35,000.00 will be recaptured (assuming none of the exceptions listed below apply). If instead the payments are $50,000.00 in the first year, $20,000.00 in the second and nothing in the third year, the recapture amount will consist of $5,000.00 from the second year (the excess over $15,000.00) plus $27,500.00 for the first year (the excess of $50,000.00 over the sum of $15,000.00 plus $7,500.00). (The $7,500.00 is the average payments for years 2 and 3 after reducing the payments by the $5,000.00 recaptured for year 2.) Needless to say, the recomputation issue is extremely complicated but I want to bring this to your attention so that we may keep it in mind when we discuss the issue of spousal support.
There are certain exceptions to the recomputation rule. There is no recomputation in the year of the event if the recipient dies, the payor dies, or the recipient remarries. However, the following are not exceptions: modifications of support, late payments, payments in a lesser amount, arrears followed by makeup payments, disability, job loss, a reduction of support, a reduction of support because of cohabitation and the refusal to accept payments. Also, there is no recomputation if the support payments are defined as “a fixed portion of the income from a business or property or from compensation for employment or self employment.” (i.e. a percentage of income is paid as and for support as opposed to a fixed amount.)
The dependency deduction for children is automatically made to the custodial parent, absent an agreement to the contrary. The custodial parent is defined as the one who “has custody for the greater portion of the calendar year.” However, the noncustodial parent may claim the dependency exemption if the custodial parent signs a declaration releasing the claim to the exemption and the noncustodial parent attaches the signed declaration to the tax return for the year in question. The actual value of the dependency exemption generally is nominal in nature. It must be remembered that the amount of the exemption (between $1,900.00-$2,000.00 for tax years 1987-1990) is only a deduction. Thus, by way of example, if you are in the 33% tax bracket, a $1,900.00 dependency exemption will save you $633.00 per year in taxes or approximately $50.00 per month. One must question the wisdom of spending hundreds, if not thousands, of dollars in attorneys fees fighting over a dependency exemption.
Sale of Family Residence to a Third Party
If the “sale” of the family residence is made to your spouses, there is not a taxable event, pursuant to IRC 1041. However, when the sale of your primary place of residence is made to a third party, Section 1034 of the Internal Revenue Code becomes very important. That section provides, in part, that if your primary place of residence is sold, and within 24 months from the date of sale you purchase a new primary place of residence, then the capital gain, if any, shall be deferred. As a general rule, in the case of a sale during a dissolution, if the house sold for $100,000, you must purchase a new primary place of residence with a purchase price of $50,000 or more within the period set forth in Section 1034 in order to defer your gain. (There are exceptions to this general rule and we should discuss them if you are going to sell your primary place of residence.)
One problem that we anticipate having in the future, although it has not yet come before the courts, is the situation where the husband moves out of the family residence and it is sold some six or seven months later. The Code requires the sale of a primary place of residence and purchase of a primary place of residence to defer the gain. When the husband has moved out, he normally rents a house or apartment and the question then becomes, what is his primary place of residence, the rented house or apartment or the old family residence? If he is not selling his primary place of residence (the old family residence), then he does not qualify under Section 1034 for deferral. We have not received any guidance from the Internal Revenue Service with respect to this problem. There are various alternatives that have been suggested by many knowledgeable people in the area including, but not limited to, entering into a formal rental or lease arrangement, obtaining an order from the court that one party leave the family residence, (traditionally referred to as a “kick-out” order) and/or entering into an agreement that the spouse leaving the family residence has exclusive use and occupancy of one room of the residence, such as a spare bedroom.
One limitation to Section 1034 is that you may sell one house only and defer the gain every 24 months, unless your sale is connected with commencing work at a new place. There are also exceptions for members of the Armed Forces. When you face 1034 problems, it is advisable that you contact your accountant or I will put you in touch with one upon request.
One way around the Section 1034 problem, and another benefit to consider, is the one-time exemption provided under the Internal Revenue Code for a taxpayer who is over 55 years of age. That provision provides, in part, that you may choose to exclude $125,000 in gain on the sale or exchange of your main home after July 26, 1978, from your gross income if you were age 55 or over before the date of the sale or exchange, and you owned and lived on the property sold or exchanged as your main home for at least three years out of the five-year period ending on the date of the sale or exchange, and you or your wife have never excluded gain on the sale or exchange of a home after July 26, 1978. A recent Internal Revenue interpretation of this provision provides that if one spouse is awarded the other spouse’s interest in the family residence, a three out of five year test must be satisfied by the spouse obtaining the interest in the family residence residing in the family residence for three out of five years following the dissolution. Thus, by way of example, if the wife is awarded the family residence and has lived in the family residence for ten years, there is an automatic exclusion up to one-half of the $125,000 for that one-half interest. However, the husband’s one-half interest that wife is awarded will not qualify for the exclusion until the wife has resided in the husband’s one-half of the family residence for three out of five years following the dissolution of the marriage.
It is important to remember that this is a one-time exclusion and it does require that neither you nor your spouse has ever excluded the gain. It may very well be that you would exclude this gain after your divorce has become final. This is one matter that we will have to discuss, if it is desirable for you to consider this.