Property Transfers Incident to Divorce

The tax consequences resulting from the transfer or division of property in a divorce impact significantly the value of the marital estate, as well as the parties’ negotiations and ultimate determination of which property or properties are allocated to which spouse. Perhaps the most significant tax provision, in terms of divorce taxation, is §1041 of the Internal Revenue Code of 1986 (the “Code”).

§1041 generally provides that no gain or loss is recognized on transfers of any type of property (real or personal, tangible or intangible) between spouses or, if incident to a divorce, former spouses, including a sale or exchange for full and adequate consideration.

Example (1): H owns $100,000 worth of stock in a liquor distributor business that has a basis of $20,000. H has political aspirations. Accordingly, he sells the stock to his wife, W, for $100,000 in cash. H does not recognize the $80,000 gain on the sale and W’s basis in the stock is $20,000. If W later sells the stock to a third party for $90,000, her gain is $70,000.

The transfer is treated as a gift and the transferee inherits the transferor’s basis in the assets. The following example illustrates the importance of the basis.

Example (2): Husband and wife own a home as joint tenants with a basis of $50,000 and a fair market value of $250,000. The home is paid for. Husband also owns marketable securities with a fair market value of $250,000 and a basis of $200,000. Pursuant to the divorce decree, wife deeds her half-interest in the house to husband who transfers all of the stocks to spouse. Both transfers are treated as gifts; therefore, no gain is recognized. Husband’s basis in the house will be $50,000 and wife’s basis in the stock will be $200,000.

In the above example, both spouses have assets worth $250,000. However, barring other Internal Revenue Code-sanctioned exclusions, Husband’s lower basis will cost him substantially more tax dollars at some point in the future.

A transfer of property between spouses, or in trust between spouses, qualifies for §1041 treatment if it occurs (1) during marriage (including the period following a legal separation but before divorce), or (2) after divorce if the transfer is “incident to divorce.” A transfer or property is incident to divorce if it (1) occurs within one year after the date that the marriage ceases, or (2) is related to the “cessation of marriage.”


A transfer pertains to the cessation of marriage if it (1) is pursuant to a divorce or a separation instrument, and (2) occurs not more than six years after the termination of marriage. A transfer that fails either of these requirements is presumed not related to the cessation of the marriage; however, either party can overcome the presumption by proving that the transfer is made to effect a division of property owned by the spouses at the time of the termination of the marriage. Annulments and marriage void ab initio are treated as divorce for purposes of §1041.

The transferee acquires the property at the transferor’s basis, whether it has appreciated or depreciated in value in the hands of the transferor. The transferor of property in a nonrecognition transaction under §1041 is required to provide the transferee, at the time of the transfer, with records sufficient to determine the adjusted basis and holding period of the property as of the transfer date.

Example (3): H owns stock with a basis of $90,000 and a value of $80,000. He sells the stock to his wife, W, for $80,000 in cash. H cannot deduct the loss, and W’s basis in the stock is $90,000. When W later sells the stock to X for $75,000, she may deduct a $15,000 loss - subject, of course, to any other restrictions imposed by law.

Normally, a donor cannot transfer to the donee the ability to deduct losses for unrealized depreciation in the value of an asset that occurred while the donor held the property.

Example (4): H owns art work with a basis of $50,000 and a value of $10,000. H gives the stock to his son as a gift. The son later sells the stock for $5,000. The son may deduct only a $5,000 loss on the sale of the stock. The loss incurred by H is unavailable to either parties.

Non-recognition treatment also extends to transfers involving the assumption of liabilities in excess of the basis of the property transferred. Normally, a transfer by gift or otherwise of mortgaged property will result in the recognition of gain if the amount of the mortgage exceeds the transferor’s basis in the property.

Section 1041 does not apply to transfers to a spouse (or a former spouse) who is a non-resident alien. Thus, if no other non-recognition provision applies, when property is transferred to a non-resident alien spouse during marriage or to a non-resident alien former spouse incident to divorce, gain or loss must be recognized.

The non-recognition of income provisions of §1041 do not override the “assignment of income” principles. In Revenue Ruling 87-112, the IRS ruled that the transferor of Series E bonds must include the deferred, accrued interest in income in the year of transfer. They reasoned that §1041 does not shield from recognition income that is ordinarily recognized upon its assignment to another taxpayer.

Transfers to third parties qualify for §1041 non-recognition treatment if they meet certain
conditions. In addition to the general requirements of §1041, the transfer must satisfy one of the following three criteria: (1) the transfer is required under the divorce or separation instrument, (2) the transfer is requested in writing by one spouse or (3) the transfer is confirmed or ratified in writing by the other spouse before filing the transferor’s tax return for the tax year of transfer. See Temp. Reg. §1.1041.1T(c), QA-9.

The transfer of property is treated as made directly to the non-transferring spouse or former spouse, who is then deemed to immediately transfer the property to the third party. The deemed transfer from the non-transferring spouse or former spouse to the third party, however, does not qualify for non-recognition of gain under Section 1041.

Example (5): Husband owns a marketable security (value of $150,000; adjusted basis of $50,000). Further, assume that the Wife has a mortgage on a vacation home of $150,000 and she requests the Husband to transfer the marketable securities to her lender. Husband incurs no tax consequence because of §1041; however, as a result of the third-party transfer, Wife will have taxable income to the extent of the gain to her of $100,000.

A closely-held business often represents the married couple’s largest marital asset and a sizable portion of their net worth. Such an asset is generally very illiquid, which necessitates the payoff of one of the spouses out of the earnings of the business. Until recently, uncertainty existed as to the proper tax treatment of a redemption of one spouse’s stock by a corporation pursuant to a divorce decree.

In Arnes, 981 F.2d 456 (CA-9, 1992), aff’g DC Wash., 4/11/91, the appellate court held that Section 1041 applied to a redemption, incident to divorce, of one spouse’s stock in a corporation wholly owned by both spouses. Accordingly, the spouse whose stock was redeemed did not recognize gain on the redemption. Perhaps of greater significance, the Ninth Circuit further held that the redemption was a constructive distribution from the corporation to the other (i.e. non-transferring) spouse. In addition to reallocating the tax burden between the parties, this second holding carries the potential for increasing and accelerating the overall tax burden on such property transfers, because the constructive distribution may be taxed as a dividend rather than a capital gain and may not qualify for installment reporting.

In Arnes, Husband and Wife jointly owned the stock of Moriah Valley Enterprises, Inc., which owned a McDonald’s franchise. The franchise agreement stipulated that only the operator could be a shareholder. (It indicated that either spouse could succeed to sole ownership).

In compliance with McDonald’s franchise agreement, H and W structured their divorce property agreement to provide that Moriah would redeem W’s stock, leaving H as the sole remaining shareholder. First, the jointly owned stock was surrendered to Moriah and cancelled, and equivalent shares of new stock were simultaneously issued 50% each to H and W in their separate names. W then transferred her new, separately owned shares to Moriah. The $450,000 redemption price was paid as follows: (1) Moriah forgave a note of approximately $110,000 owed to it by W, (2) $50,000 was paid in cash, and (3) the $290,000 balance would be paid to W in ten annual installments. In addition, H personally guaranteed the installment payments.

W’s basis in her stock was negligible ($2,500), and virtually all of the redemption proceeds were taxable. W reported the resulting gain (approximately $177,000 in the year at issue) on the installment method. Thereafter, W sued for a refund on the theory that the redemption was shielded from tax by Section 1041 as a transfer incident to divorce. The transfer, although in form between Moriah and W, was in substance made “on behalf of” H and thus was a qualifying transfer between former spouses.

The court found that the stock redemption from Moriah Enterprises was required by a divorce instrument to which both plaintiff and her ex-husband were parties. The Court also held that Husband benefitted by the transaction because it was part of the marital property settlement with his wife. Husband limited future community property claims that plaintiff might have brought against him by agreeing to Moriah’s redemption of Wife’s stock for $450,000.

Accordingly, the Court held that the corporation made distributions to Husband who purchased Wife’s stock in a transaction which qualified for non-recognition of income pursuant to §1041.

The non-recognition provision can be used to assign gains and losses on assets owned by the spouses to the spouse in the more advantageous marginal tax bracket. In deciding how to divide their assets, they should consider having the spouse in the lower bracket take those assets that have had the greatest appreciation in value and having the higher bracket spouse take assets that have had the least appreciation in value or that have declined in value. The spouses’ ability to assign potential gains and losses between themselves can be advantageous even if they are in the same marginal income tax bracket.