Q: I am in the middle of a very difficult divorce, and am contemplating giving my wife the family home. We bought it many years ago for $40,000 and it is now worth about $200,000. If I give the property to my wife, are there any taxable consequences?
A: It is almost impossible in this short column to give a comprehensive explanation of the tax consequences when divorcing partners transfer the family home. However, I will attempt to highlight some of the major items that should concern you. You must discuss these issues with your lawyer and your tax adviser before you enter into any settlement agreement with your wife.
Before 1984, the law generally was that the transfer of property between a husband and a wife, where it was an exchange for the release of the marital rights, created a taxable event.
If, for example, the husband transferred the property to the wife, the appreciated value above his adjusted cost basis was taxable gain. In other words, before 1984, if you purchased the property together for $40,000 each of you had a tax basis of $20,000.
If the husband transferred the property to the wife when the property was worth $200,000 the husband's share was $100,000. Thus, his taxable gain was $80,000 ($100,000 minus $20,000).
If he did not roll over the gain by purchasing a new house within two years for at least $100,000, he would have to pay capital gains tax. Additionally, if he was older than 55, and had lived in the house for three out of the past five years, he was entitled to the once-in-a-lifetime exclusion.
However, on July 19, 1984, Congress enacted significant tax changes when it passed the Deficit Reduction Act of 1984. Effective on that date, the law dramatically changed. For transfers of property between spouses -- or former spouses -- after July 18, 1984, no gain or loss is recognized against the transferor if the transfer occurs during the marriage or is "incident to a divorce."
A transfer is "incident to the divorce" if it occurs within one year after the marriage ceases, or if it is related to the cessation of the marriage. It is to be noted that these new tax laws apply only if the transferee is a U.S. citizen.
The Internal Revenue Service takes the position that any transfer that is not made under a divorce or separation instrument or that does not occur within six years after the end of the marriage, is presumed to be not related to the ending of the marriage. However, if you can show that the division of the property was made to carry out the division of property owned by the spouses at the time the marriage ended, the presumption will not apply.
Thus, under the new laws, no gain or loss is recognized when one spouse transfers the property to the other, and in such cases, the cost basis of the transferred property in the hands of the transferee (the wife in this case) is the adjusted basis the couple had in the property -- the original cost of the property, $40,000.
Since the husband recognizes no gain when he transfers the property, he need not be concerned about paying any tax, and thus he does not have to concern himself about the rollover provision or even the once-in-a-lifetime "over 55" exemption.
However, the wife, who is now the sole owner of the property, can take advantage of these two provisions if and when she sells the property. If, on the other hand, she sells but does not meet the test for these two "tax shelters," she would have to pay the tax on the entire property.
But let us look at a somewhat different example.
Instead of transferring the property now to the wife, the parties agree that they will obtain a divorce decree, but will sell the house at a future time, when, for example, the children have left the family home. The wife will get all of the proceeds. Under these circumstances, the law automatically treats the now-divorced parties as owning the property as "tenants in common" rather than tenants by the entirety or joint tenants.
If the divorce decree, or the marital property settlement, was entered into after July 18, 1984, even if the property is sold several years after the divorce, it can be argued that the transfer is "incident to the divorce."
According to Section 1041 of the Internal Revenue Code, a transfer of property is incident to the divorce if such transfer:
Occurs within one year after the date on which the marriage ceases.
Is related to the cessation of the marriage.
In our example, if both husband and wife, now divorced, sell the property to a third party, and the wife keeps all of the sales proceeds, it may be argued that the husband has no gain and the wife has all of the gain.
Thus, the wife -- in order to shelter this gain -- will either have to buy a new house equal to or greater than the selling price of the old house, or she can take advantage of the once-in-a-lifetime exemption, if she qualifies for those rules.
However, there is one serious pitfall. In our example, the husband and wife agree to obtain a divorce, with the wife staying in the property for several years until the children leave home, and then the house will be sold. However, instead of the wife keeping all of the sales proceeds, the parties agree that the proceeds will be divided equally.
Under these circumstances, when the property is sold, the wife can take advantage of the rollover rules and possibly the once-in-a-lifetime exemption. She has been residing in the property. However, the husband may find himself in serious tax trouble.
In this example, the IRS may argue that the husband has realized gain from the sale of the property. Since he has not lived in the property for two years, he will not be able to take advantage of the rollover.
More important, even if he is older than 55, since he has not lived in the property for three out of the last five years, he will find himself unable to take advantage of the so-called senior citizen exemption. Thus, the husband can be hit with significant tax on his gain, which for tax purposes today ranges from 28 percent to 33 percent.
Careful tax planning must be an element of any divorce settlement. Both husband and wife must seek independent legal and tax advice before committing themselves to any binding agreement.
Benny L. Kass is a Washington attorney. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers also may send questions to him at that address.