Transfer of Property in Divorce: Will I be Taxed?

During divorce settlement discussions, spouses can be very creative in their agreements to divide assets and debts. Spouses may consider an equal or unequal division of community property, the transfer of separate property assets from one spouse to another, payments to the other to “equalize” the division of assets and debts, and may have to deal with how to manage nonvested and vested stock options, gains on the sale of real property, net operating losses of businesses, and many other issues. Each spouse should be informed of possible tax issues related to the assets being divided, and whether their agreements will impact their tax liability now and in the future. The purpose of this article is to provide a primer on “nontaxable events” related to property division agreements between spouses finalizing their dissolution of marriage. 

Nontaxable Events

To most parties’ great relief, the bulk of most property-division agreements falls under the umbrella of transfers “incident to divorce.”

Specifically, “gain” or “loss” is not recognized upon a property transfer (including money) between spouses if the transfer is incident to divorce. In plain English, the transfer does not create a taxable event and neither spouse will be taxed.

In most cases, marital settlement agreements often result in the unequal division of community property, giving one spouse a bit more, or a lot more, than one-half of the community interest. In return, the spouse receiving more may pay an “equalizing” payment to the other to balance the scales. Are these agreements considered to be transferred “incident to divorce?” 

Transfers “Incident to Divorce”

In most cases, the answer to the above question is “yes,” but there are important caveats.

A transfer is “incident to divorce” if it (1) occurs within one year after the date the marriage ceases, or (2) “is related to the cessation of the marriage.”

1. A property transfer between former spouses that occurs within one year after entry of final judgment of dissolution is an “incident to divorce” even if it was not related to the cessation of marriage, and even if the property was not acquired by the transferor until after the divorce.
2. A transfer is “related to the cessation of marriage” if it is made pursuant to a “divorce or separation instrument” and it occurs not more than six years after the date upon which the judgment of dissolution is final. 

The timelines provide both advantages and disadvantages to divorced spouses which should be considered with both your divorce attorney and tax professionals prior to entering into a marital settlement agreement, within the year following entry of final judgment, and prior to the six years after cessation of marriage if specific transfers have not yet been completed. 

Taxes Concerns Unrelated to the Transfer

Although spouses obtain relief from the Internal Revenue Code in relation to gains and losses involved in the transfer of property “incident to divorce,” they should still be wary of tax consequences related to the assets received unrelated to the transfer. 

On a positive note, under current law, if a residence is transferred to a spouse in property settlement agreements, the transfer will not be considered a “change of ownership” triggering a reappraisal for property tax purposes under California law. This saves the spouse receiving the property from the possibility of owing more in annual property tax payments. 

On a more concerning note for spouses, requiring further investigation and intuitive negotiation in the settlement, each spouse should be aware of differing “bases” of the property received by each of them, potentially creating unequal tax consequences. Otherwise, you may think you’ve received an “equal and fair deal,” while ultimately acquiring more tax liability than your spouse. Again, this is a must-have discussion with your family law attorney and tax professionals because the complexities are beyond the scope of this article. 

Each couple has differing assets and debts that make up their marital estate and those assets may come with their own tax consequences. Stock options, real estate sales, and business net operating losses are some of the most common items involving tax-centric concerns. It is important to educate yourself on the tax-related issues concerning your assets and debts before blindly agreeing to a specific division of those property items. 

It is important to know your rights, responsibilities, and options regarding tax issues incident to divorce or legal separation. Our family law team at Naimish & Lewis can advise you on this and other family law matters. To schedule an initial consultation with an attorney at our firm, please contact us.