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Tax Aspects of Property Transfers

The Taxpayer Relief Act of 1997 has provided significant changes to the income tax map for individuals and businesses. Some changes which affect the arena of separation and divorce are as follows:

  • The sale of a home is easier due to a new exclusion for capital gains.
  • The dependency exemption is more valuable because three new credits and a deduction are tied to it.
  • The lower capital gains income tax makes property with a low basis more valuable.
  • New IRA rules can make it easier to utilize IRA funds for alimony and equitable distribution.
  • The foregoing changes are incorporated in the following materials.

Property Transfers
  • The Pennsylvania Divorce Code provides that tax consequences of the property division are one of the eleven factors to be considered in determining equitable distribution. 23 Pa.C.S.A. 3502(a)(10).

  • Prior to the Tax Reform Act of 1984:

    • United States v. Davis, 370 U.S. 65 (1962) held that a transfer of property titled in the name of one spouse to the other spouse in satisfaction of that other spouse’s marital rights was a taxable transfer of property whereby the transferor of the property would recognize a gain or loss on the transfer as if the transfer to the recipient spouse was an arm’s length sale at the fair market value of the property as of time of the transfer.
    • The spouse to whom the property was transferred then took such property at a stepped-up basis, a basis equal to the property’s fair market value at the date of transfer.

  • Property Transfers Pursuant to the Tax Reform Act of 1984:

    • The Act made the transfer of property in the context of marital dissolution a non-taxable event. The transferee spouse taking property pursuant to the marital dissolution would receive the property with the transferor’s adjusted basis in the property.
    • Section 1041(b)(1) makes the rule set forth in Section 1015 applicable to transfers of property pursuant to marital dissolution. Section 1015 provides that when a donor transfers property by gift to a donee, the donee reports no income upon receipt of the gift.
    • Section 1041 applies if the transfer is incident to a divorce. For the transfer to be incident to a divorce, it must occur within one year of the divorce or be related to the cessation of the marriage. IRC 1041(2).
    • If the transfer does not occur within one year, but occurs not greater than six years after the cessation of the marriage pursuant to a divorce or separation agreement, it will be considered related to the cessation of marriage and subject to the nonrecognition provisions of Section 1041. Temp. Reg 1-1041-1T (A-7).
    • For good cause shown, the Internal Revenue Service may waive the time period. Good cause may be shown where there was a legal or business impediment to the transfer or a dispute as to the nature or value of the assets to be transferred.
    • The Section 1041 nonrecognition provisions are mandatory and cannot be elected by either spouse.
    • Section 1041 nonrecognition treatment is available for transfer to a third party so long as the transfer is required by a divorce or separation instrument, the transfer is made on behalf of a spouse or former spouse, at that spouse’s request, or the transfer by consent in writing by the other spouse. See Temp. Reg 1-1041-1T(A-9).

  • Transfer of Personal Residence Prior to the Taxpayer Relief Act of 1997:

    • Section 1034 which provided for a deferral of gain on the sale of a personal residence has been totally transformed. Previously it provided for deferral if the taxpayer met three requirements:

      • the old residence must have been the taxpayer’s prior “principal residence”;
      • the new residence purchased must have been the taxpayer’s new “principal residence”; and
      • the new residence must have been acquired within the time period two years before the sale and ending two years after the sale of the old residence. IRC 1034(a).

    • Perry v. Commissioner, T.C. Memo 1994-247 (1994), addressed the determination of whether a residence is a party’s principal residence in the context of divorce. Husband and Wife resided in marital property until June, 1984, when husband moved to a friend’s house. In August or September, 1984, Husband moved into the home of his girlfriend. He continued to make the monthly mortgage payments directly to the lender until June, 1985, plus he paid the real estate taxes, insurance and utilities on the property. In the summer, 1985, husband and wife began to share these expenses, plus husband paid for repairs without reimbursement from wife. The parties’ marriage was “legally terminated” in 1985, and they entered into a Property Settlement Agreement that provided for wife’s exclusive possession of the marital residence for two years, until December, 1987, after which the property would be sold and the proceeds would be divided equally. Prior to sale, husband married his current wife in April, 1987. The property was sold in March, 1988. Husband and his new wife recognized no gain on the sale of that property, indicating, instead, pursuant to Form 2119, that they intended to purchase a replacement home within the two-year period, which they did in August, 1989.

      • The IRS determined that the former marital residence was not subject to nonrecognition and, therefore, determined a deficiency existed in husband’s (and his new wife’s) federal income taxes. The IRS determined that the former marital residence was not the husband’s “principal residence.”
      • In upholding the Commissioner’s determination, the Perry Tax Court explained “principal residence” as follows:
      • The phrase “principal residence” is not defined by the Code; however, Section 1.1034-1(c)(3), Income Tax Regs., provides that the determination of whether or not property is used by the taxpayer as his principal residence “depends upon all the facts and circumstances in each case, including the good faith of the taxpayer.” Generally, for property to be “used by the taxpayer as his principal residence” within the meaning of Section 1034(a), that taxpayer must physically occupy and live in the dwelling...Whether property constitutes a principal residence depends entirely upon the facts and circumstances in each case, and, based on the facts and circumstances in some cases, certain property has been considered as the principal residence of taxpayers even though the taxpayers were not physically present at the residence at the time of its sale...Those cases involve situations where the property was rented instead of sold after the taxpayers moved out because of facts and circumstances over which the taxpayers had no control.

      • Where there are exigent circumstances, such as the inability to sell the property due to the real estate market, notwithstanding that the parties have vacated the premises, the property remains the taxpayers’ principal residence since they were attempting to sell the property at the earliest possible date (and the rental of the property in that instance was caused by conditions in the real estate market and was incident to efforts to sell the property). Clapham v. Commissioner, 63 T.C. 505 (1975).
      • In Young v. Commissioner, T.C. Memo 1985-127, a taxpayer’s divorce settlement granted his former wife a 75% interest in their home and her exclusive right of possession. Taxpayer was to pay alimony as well as the mortgage, real estate taxes and homeowner’s insurance, and he vacated the home. Subsequently, he purchased a new home with his new wife. The Tax Court held that the residence was not the taxpayer’s “principal residence” within the meaning of Section 1034 since it ceased to be his new residence, as he had no intention of returning and had not lived there for more than two years prior to its sale.
      • In accordance with Young, the Perry Tax Court found that the house which the Perry’s sold was not Mr. Perry’s principal residence and he did not qualify for deferral of recognition treatment. Therefore, once a spouse moved, his or her house was no longer his or her principal residence for deferral of recognition purposes.

    • Joint Election and Use of Section 1034
    • Prior to the enactment of the Taxpayer Relief Act of 1997, a husband and wife could elect to have Section 1034 apply to them jointly regardless of actual ownership in the new and old residences. IRC 1034(g). The adjusted sales price and cost of the new residence to each spouse were combined, and the unrecognized gain as a reduction in basis was allocated between the spouses. If no election under Section 1034(g) was made, each spouse was treated as separately owning one-half interest in the jointly owned personal residence. Each spouse was permitted to separately qualify for the tax-free rollover of the gain. Rev. Rul. 74- 250, 1974-1 C.B. 202.

    • Once-in-a-Lifetime Exclusion
    • Section 121 permitted a once-in-a-lifetime exclusion of gain. A taxpayer could have exempted for all time gain of up to $125,000.00 from the sale of the taxpayer’s old residence providing four requirements were met:

      • Taxpayer was 55 years or older before the date of the sale. IRC 121(a)(1);
      • Taxpayer must have owned and used the property as the principal residence for periods of time which total in the aggregate three years in the five years immediately prior to the date of the sale. IRC 1219(a)(2);
      • Taxpayer must elect treatment under IRC Section 121 and such election could be made only once in a lifetime. IRC 121(b)(1)(2); and
      • Up to $125,000.00 of the gain could be excluded. IRC 121(b)(1).
      • Where married parties filed separate returns, the excluded gain was limited to $62,500.00. Where the property was transferred pursuant to marital dissolution and qualified for nonrecognition treatment pursuant to Section 1041, Section 121 did not apply since the spouse transferring the property would not have taxable gain to exclude from income. Under those circumstances the Section 121 election was preserved for both spouses, so that each could “take” $125,000.00 for a total of $250,000.00. If a spouse who made a Section 121 election remarried one who had not made the Section 121 election, the new spouse lost the right to make the election (so long as he/she was married to said taxpayer).

  • Transfer of Personal Residence Pursuant to the Taxpayer Relief Act of 1997.
  • Each spouse in a divorce can now exclude up to $250,000.00 gain from the sale of the marital home.

    • The requirements are:

      • the spouse owned the home and used it as his or her principal residence for two out of five years before the sale; and
      • the spouse did not already use the exclusion during the two years before the sale.

    • The new law applies to all sales after May 6, 1997.
    • In the past, a spouse might have “rolled over” the gain into a new home or taken the once-in-a-lifetime $125,000.00 exclusion for persons age 55 or older. But both of these options caused problems for the owners and for the IRS. Both Code provisions were repealed by the new law.
    • If one spouse moves from the home and the other continues to use it as his or her principal residence for a period of time pursuant to a divorce decree or separation agreement, the spouse who has moved can “count” this time.
    • Example: A husband moves, and the divorce decree provides that the wife will remain in the home for seven more years and then the home must be sold and the proceeds split. The husband will be treated as if he lived in the home during those seven years, and will be able to use the exclusion.

      Note: Spouses cannot count the time from when they moved until decree or agreement when into effect. If this period is more than three years, then the decree or agreement should provide for the other spouse to stay in the home for at least two additional years, so the moving spouse can meet the two-out- of-five years requirement.

    • There is no age requirement and the exclusion can be used once every two years rather than once in a lifetime. The Section 1034 “55 or over” age requirement has been repealed.
    • If a home is sold before the divorce, and the couple files a joint return, they can exclude up to $500,000.00 even if the home was owned by just one of them.
    • If a home was owned by one spouse during the marriage and then transferred to the other as part of the divorce, the receiving spouse can use the $250,000.00 exclusion even if the home is sold less than two years later. That is because the former spouse’s time of ownership “counts” for purposes of the two-out- of-five years requirement.
    • If a spouse uses the exclusion and then remarries, the new spouse is still eligible for the exclusion and can even use it less than two years later. (With the old “55 or over” exclusion, the new spouse would not be able to use it anytime during the marriage.)
    • The rule that a spouse who moves out can “count” the time that the other spouse remains in the house does not just apply to the marital home. For instance, if a decree or agreement provides for a spouse to live in a vacation home or new home that the spouses jointly own, both spouses can later exclude gain on the sale.
    • The exclusion does not apply to gain that results from certain depreciation deductions taken for events occurring after May 6, 1997. (This might include a deduction for a home office or a rental of part of the home). If one spouse stays in the home and takes deductions, and then the home is sold by both spouses, both will pay income tax on the gain even though only one received the benefit of the deductions.

  • Transfer of Retirement Benefits

    • A domestic relations order which is qualified by a plan administrator is one of the few exceptions to the non-alienation provisions of ERISA. It is commonly referred to as a Qualified Domestic Relations Order (QDRO).
    • Pursuant to 20 U.S.C. Section 1056(d)(3), the nonforfeiture and non-alienation provisions of ERISA “shall not apply if the [domestic relations] order is determined to be a qualified domestic relations order.”
    • To be a Qualified Domestic Relations Order, a domestic relations order must specify, inter alia, a specific amount or percentage of the participant’s benefit to be paid to the other spouse (called an alternate payee) where the manner in which the specific amount or percentage is to be covered. 29 U.S.C. 1056(d)(3)(C)(ii); IRC 414℗(2)(b).
    • The alternate payee of the plan takes the pre-tax deposits into such a plan subject to later income taxation upon withdrawal.
    • The alternate payee cannot, without penalty and income taxation, withdraw the funds prior to the occurrence of an event which would allow the plan to go into pay status with respect to the participant spouse or allow the participant spouse to make such a withdrawal without penalty.
    • If there is a direct transfer to the spouse pursuant to a Qualified Domestic Relations Order prior to establishment of a separate qualified plan vehicle, no ten (10%) percent penalty is payable, although there will be income taxation.

  • Tax Refunds.

    • Conflicting Pennsylvania Superior Court decisions have issued regarding income tax refunds:

      • The Superior Court has held that refusal to file a joint tax return, where the effect of filing jointly would reduce the overall tax liability, is a dissipation of an asset for purposes of equitable distribution. Gruver v. Gruver, 372 Pa. Super. 194, 539 A.2d 395, appeal denied, 320 Pa. 685, 553 A.2d 968 (1988). But, it has also been held to the contrary. Hunsinger v. Hunsinger, 387 Pa. Super. 453, 554 A.2d 89 (1989).
      • The Pennsylvania Superior Court held that a “refund retains the character of the payment from which it was withhold.” Cerny v. Cerny, ____ Pa. Super. _____, 656 A.2d 507 (1995).

    • The apparent conflict is based upon the scope of review by an appellate court. This abuse of discretion standard upon appeal essentially lets an equitable distribution trial court’s decision stand if there was substantial competent evidence to support the lower court’s decisions. Thus, non-joinder in an income tax return may constitute dissipation of an asset in one case, but not in another case.

  • Miscellaneous Considerations.

    • Operating loss tax benefits are transferable.
    • Stock options which are not transferable can still be the subject of a property distribution agreement or order.
    • Limited partnership excess deductions may be recaptured and imposed on the parties in future.
    • Spouses may make a gift to a third person of $20,000.00 per year and both of their annual exclusions will apply in equal shares against the gift tax imposed on the gift in excess of the annual exclusion. Where spouses use such a “split-gift” provision, they must consent to do so.
    • Interest payable to a recipient spouse on installment payments is income taxable to the recipient, but may not be deductible by the payor spouse. The payor spouse can deduct the interest payments if they are treated as alimony.
    • Property is transferred from one spouse to another, with
    • transferor basis, which may be substantially depreciated.
    • To the extent ownership of a life insurance policy or annuity is transferred, the transfer of the case value of the policy or annuity is subject to the nonrecognition provisions of Section 1041.
    • Life insurance and annuity payments are generally not taxed to the recipient spouse unless the premiums paid on the policy were paid by a third party (such as an employer).

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