Taxes & Divorce: The Tax Consequences of Equitable Distribution

By Gregory Herman-Giddens, J.D., LL.M., CFP®     March 19, 2010

Gregory Herman-Giddens

Introduction

With about one-half of all marriages in the U.S. ending in divorce, the unfortunate fact is that one can never be sure that one will be with one’s spouse for a lifetime.  Given the high cost of divorce, it is important to be aware of the financial issues involved.  This article will focus on one such issue – the income tax consequences of equitable distribution. Equitable distribution is the process by which martial assets are divided by a court in a divorce proceeding, the purpose of which is to provide a fair allocation of the property between the spouses.  Typical state laws provide that an equal division is equitable, and  presume that an in‑kind distribution of marital property is equitable.”  However, no distribution of assets can be considered equitable without a full consideration of the tax implications to both parties.

As part of the Tax Reform Act of 1984, Congress enacted Internal Revenue Code (IRC) Section 1041 in response to the disparities and varying treatment of marital property upon divorce.  Pursuant to § 1041, transfers of property between former spouses incident to a divorce are treated as a gift; therefore, the transferee spouse can exclude the property received from his or her gross income under Section 102(a).  A transfer of property is incident to a divorce if it occurs (1) within one year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage.  A transfer is related to the cessation of the marriage if it is made (a) by virtue of a divorce or separation instrument, and (b) is transferred no more than six years after the cessation of the marriage.  Section 1041 has broad applicability; however, the rule does not apply if the transferee is a non-resident of the United States, because the non-resident alien may not be subject to tax on a later disposition of the property.