When a Marriage Ends, Tax Planning Doesn't

Divorce is not a pleasant topic. But if you and your spouse own a home and are contemplating a divorce, you must do some careful tax planning as early as possible.

Your house is probably your largest asset. You probably would like to keep it. If it has to be sold, you want to pay as little tax as possible.

Married taxpayers filing jointly can exclude from taxation up to $500,000 of any profit they make when the house is sold, if during the five years before the sale they each lived in the house for at least two years and at least one spouse owned the home for at least two years. Single people or married taxpayers filing separate tax returns can protect only $250,000 of capital gain.

How does this affect a divorcing couple?

Look at this example: A couple bought a house for $200,000. It is now worth about $500,000. They have three children who want to stay in the house until they complete high school. The husband has agreed to move out, but the wife will stay in the house at least until the children reach age 18. (There's no sex bias in this tax law; the treatment is the same whether the man or woman stays in the house.)

In some situations, the husband will agree, pursuant to a divorce settlement, to immediately transfer his half-interest in the property to the wife. Alternatively, the two may agree that the husband will retain ownership of his share of the property until some later time when it is sold, at which time any profit will be distributed pursuant to their divorce or separation agreements.

It is important to consider the tax implications for both scenarios. Where the husband transfers his share of the house to the wife, under certain circumstances the law treats it as a nontaxable event. Since 1984, under Section 1041 of the Internal Revenue Code, transfer of property between spouses or former spouses is considered nonrecognized gain and so isn't taxable. However, the transfer has to be during the marriage, or "incident to a divorce."

The concept of "incident to a divorce" is significant. According to Section 1041, a transfer of property is incident to the divorce if it occurs within a year of the date on which the marriage ceases, or is related to the cessation of the marriage.

The IRS has taken the position that if the transfer is specifically spelled out in the divorce or separation agreement, it is incident to the divorce only if the transfer occurs within six years of the date on which the marriage ends.

The nonrecognition of gain concept is not applicable for transfers to spouses or former spouses who are nonresident aliens.

For transfers that are not made under a divorce or separation instrument, or that do not occur within six years of the end of the marriage, there is a presumption that the transfer was not related to the ending of the marriage. That presumption can be overcome if the parties can demonstrate facts to support the position that it was part of their divorce obligations.

In our example, the property was purchased for $200,000. Assuming no improvements were made to the property, the husband's basis in the property is $100,000. If the husband were to transfer his half-interest in the property to the wife, he would have no taxable consequences. The wife, however, would pick up the husband's basis in the property ($100,000), and her basis would become $200,000.