Division of Particular Types of Property
This section will address the transfers of specific types of property incident to divorce and the tax consequences that may result. The Internal Revenue Code provides for a notice and recordkeeping requirement with respect to any transfers incident to divorce under § 1041. At the time of the transfer, the transferor must provide the transferee spouse records that indicate the adjusted basis and holding period of the property. Similarly, if the asset has the potential for investment tax credit recapture, the transferor spouse must provide the transferee spouse with adequate records to determine the amount and period of any potential liability.
The marital residence is often the largest marital asset. With regard to determining the taxable gain upon sale of the primary residence, IRC § 121 provides that a single taxpayer can exclude up to $250,000 in gain, provided he or she has lived there for two out of the last five years. Married couples filing jointly may exclude up to $500,000.
There are various ways for dividing the marital home, depending on the preference of the parties, and each has its own particular tax consequences. The four most common ways to divide the martial residence can be classified as: (1) equal aggregate value division, (2) equalizing payment division, (3) sale and division of the proceeds, and (4) continued co-ownership.
(1) Equal Aggregate Value Division. This occurs if one spouse decides to remain in the principal marital residence. In this situation, the residence would be allocated to one spouse as his or her property, and marital property of equal value would be allocated to the other spouse. Under §1041, the sale by one spouse of his or her interest in the home to the other is a tax-free event. There are no tax consequences with an equal aggregate value division of the marital property. The selling spouse takes the proceeds without gain recognition and the purchasing spouse takes the seller’s basis, as opposed to a cost basis which normally happens for transfers that are not incident to a divorce.
(2) Equalizing Payment Division. This takes place when one spouse buys the other spouse out of the marital residence. Under this approach, the home may be allocated to one spouse who makes an equalizing payment to the other spouse. This type of equalizing transfer is treated as a non-taxable transaction under § 1041. The spouse who receives the note or other equalizing payment incurs no tax consequences, because there is no sale or exchange to this spouse. Consequently, the transferee spouse receives a basis in the residence equal to the couple's basis in the residence before the transfer. For purposes of a subsequent sale of the principal residence pursuant to § 121, the seller spouse is deemed to have owned the property for the entire period the transferor owned the property. This rule is beneficial to the transferee spouse if he or she chooses to sell the property in the future, because it will make it easier to exclude the gain from the sale of the property from his or her gross income by making it more likely that the transferee spouse will meet the ownership and use requirements of § 121.
(3) Sale and Division of the Proceeds. This occurs if the spouses sell the residence to third party and divide the proceeds among themselves. In this situation, the martial residence can be sold, with the proceeds of the sale divided equally between the parties. This type of division usually triggers a gain which must be recognized by both spouses. Each spouse must recognize his and her portion of the gain realized, if any, on the sale, unless non-recognition treatment applies. The gain could be exempt from recognition if it meets the requirements of § 121 for the sale of a principal residence or qualifies as a “tax-free” exchange under IRC § 1031. For example, if the martial residence is sold pursuant to a divorce agreement and the proceeds are divided between the parties, each spouse’s share of the gain is eligible for exclusion, so long as it does not exceed $250,000.
(4) Continued Co-Ownership. This is when both spouses continue to own the residence as tenants-in-common. Typically, the spouse with custody of the children will be entitled to possession. The custodial spouse will often possess the residence until either death or remarriage or until the youngest child reaches the age of majority. There are no tax consequences until the home is sold, because there has been no disposition. When the home is sold, the spouse in possession must recognize gain from the sale to the extent that non-recognition treatment fails to apply.
The spouse who is not in possession of the marital home may be affected under the Continued Co-Ownership approach. Because the house is no longer his or her principal residence, non-recognition treatment cannot apply. However, if the non-possession spouse sells his or her interest in the home to the possession spouse through a divorce instrument, §1041 permits non-recognition of gain.
Additionally, the non-possession spouse can also use the two-out-of-five years rule of § 121 to exclude any gain from the sale of the principal residence from his gross income. For example, if the marital home is not to be sold for several years following the divorce, the non-possession spouse's failure to qualify for the exclusion for lack of use can be remedied by proper planning at the time of the divorce. If the decree specifies that one of the spouses may continue to reside in the home (the possession spouse), and if the home continues to be owned, or partly owned, by the non-possession spouse, then that spouse is considered meeting the two-out-of-five years use test as well.
Example: Marty and Renee have owned their house jointly for many years. Marty moves out. The divorce decree provides that Renee may continue to reside in their home. She lives there for six more years and then sells the house for a gain of $450,000. Both Marty and Renee are entitled to exclude $225,000 of the gain, because the two-out-of-five rule regarding ownership and use is satisfied.