Tax Treatment of Property in Divorce

Generally, no gain or loss is recognized by either party on a transfer of property from an individual to a spouse, or a former spouse if the transfer is incident to divorce. When nonrecognition treatment applies under this rule, the spouse who receives the property in the transfer is treated as acquiring the property by gift rather than sale or exchange and his or her basis in the property is equal to the transferor spouse’s adjusted basis in the property immediately before the transfer. A transfer of property is treated as incident to divorce if

1) the transfer occurs within one year after the date on which the marriage ends or
2) the transfer is related to the ending of the marriage.

 A transfer of property is treated as related to the ending of the marriage if the transfer is pursuant to a divorce or separation instrument and the transfer occurs within six years after the date the marriage ends. 

It is important to note that the nonrecognition rule does not apply if the transferee spouse is a nonresident alien. The non-recognition rule also does not apply to a transfer of property in trust to the extent the amount of any liabilities assumed or liabilities to which the property is subject exceeds the adjusted basis of the property. The transferee spouse’s adjusted basis in the property must be adjusted to take into account any gain recognized under this exception to the non-recognition rule. The tax treatment of a redemption of stock depends on whether the transferee spouse is treated under applicable tax law as receiving a constructive distribution when the transferor spouse receives property for the redeemed stock. This may occur, for example, when the transferee spouse is under a primary and unconditional obligation to buy the transferor spouse’s shares. 

1. If the transferor spouse’s receipt of property for the redeemed stock is treated as resulting in a constructive distribution to the transferee spouse, then the redeemed stock is deemed first to be transferred by the transferor spouse to the transferee spouse, and then transferred by the transferee spouse to the redeeming corporation. Any property the transferor spouse actually receives from the redeeming corporation is deemed first to be transferred by the redeeming corporation to the transferee spouse in redemption of that spouse’s stock, and then transferred by the transferee spouse to the transferor spouse. The nonrecognition rule applies to the deemed transfers between the two spouses. However, it does not apply to the deemed transfers between the transferee spouse and the redeeming corporation.
2. If the transferor spouse’s receipt of property for the redeemed stock is not treated as resulting in a constructive distribution to the transferee spouse, then the transferor spouse is treated simply as having received a distribution from the corporation in redemption of stock, and the nonrecognition rule does not apply.

 If a divorce or separation instrument or any other valid written agreement between the spouses expressly provides that both spouses intend for the redemption to be treated as resulting in a constructive distribution to the transferee spouse, then the treatment under (1) above applies no matter what the applicable tax law provides. On the other hand, when such an instrument or agreement expressly provides that both spouses intend for the redemption to be treated as a redemption distribution to the transferor spouse, then the treatment under (2) above applies no matter what the applicable tax law provides. A taxpayer should contact a tax advisor to discuss the rules regarding transfers resulting from a divorce as they apply to their specific situation.

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