This blog is part three of a three-part series discussing how a divorce could affect your taxes. You can read the first blog post in this series here, and the second here.
In 1962, the United States Supreme Court decided United States v. Davis, which created difficulties for divorcing parties and attorneys. Although, there was no sale and no money changing hands, the transfer of appreciated property in exchange for marital rights was considered to be a “sale” with the transferor liable for payment of capital gains taxes. The gain was determined by the fair market value of the asset on the date of the transfer with the transferor deemed to have received the value equal to that portion of the fair market value transferred to the other spouse. Conversely, the transferee was charged with neither gain nor loss because the marital rights relinquished were not “appreciated property,” even though these rights were considered to be equal in value to the value of the property received. Thus, the transferee of appreciated property received it on a “stepped up” basis equal to the fair market value of the property received.
Imposing a tax on the transferor of property incident to a divorce was largely viewed as a perverse tax consequence since the transferor, who was parting with an asset like the marital residence (and often reluctantly so), considered the imposition of a tax in addition to the taking of an asset to be punitive.
The Domestic Relations Tax Reform Act of 1984 changed the Davis rule so that divorce related transfers after July 18, 1984 are treated as gifts which result in neither gain nor loss to either party and thus have no tax consequences. The transferee receives the asset at the original basis rather than the stepped up basis and is taxed on the gain when the property is ultimately sold. The transfer is not a taxable event since no tax is immediately imposed on the transferred property.
With regard to transfers of appreciated property, such as real estate or stock between spouses incident to a divorce, prior to 1984 these were considered to be taxable events. The transferor was subject to capital gains taxes on the gain from the original basis of the property to the fair market value on the date of transfer. The theory justifying the tax was that even if the transferor received no money, the consideration for the transfer was “money’s worth” in exchange for the transfer. Again, the transferee took the property at the new “stepped up basis”. The Domestic Relations Tax Reform Act of 1984 likewise changed the law by providing that the property would pass to the transferee at the original basis with no tax imposed. Of course, the transferee was required to eventually pay the capital gains taxes or qualify for an exemption when the property was ultimately sold.
The shift of the tax burden from the transferor to the transferee was temporarily rendered more onerous with the passage of the Tax Reform Act of 1986 that eliminated preferential capital gains tax treatment and imposed tax on capital gains at ordinary income tax rates. The Taxpayer Relief Act of 1997 eliminated taxes on capital gains of up to $250,000 realized from the sale or exchange of the taxpayer’s principal residence.
Deferred compensation payments from non-qualified plans and stock options transferred incident to divorce do not trigger an immediate tax consequence to the transferor. The tax liability is imposed on the transferee upon exercise of the options or receipt of the deferred compensation. However, cashing out a retirement account and transferring the proceeds results in an imposition of tax to the transferor. To avoid an immediate tax consequence, the transfer must be made of the transferor’s interest in the account by way of a rollover directly into the transferee’s account or by changing the name on the account.
With regard to dependency exemptions, prior to 1984 a parent could claim a child if he or she paid more than 50% of the child’s support for the year in question. Application of this test generated disputes between parents and significant administrative problems for the IRS. In cases where both parties claimed the dependency exemption, they were required at an audit (usually years later) to produce proof of their expenditures for food, clothing, medical care, shelter and so on.
These provisions were changed in 1984 to entitle the primary custodial parent to claim the child absent a written waiver to the other parent. This was an important feature because as personal exemptions were phased out for high income taxpayers, it cost little or nothing for a payor in a high income tax bracket to grant the exemption to the other party for whom the exemption actually confers a benefit.
Congress created an additional benefit to parents in 1997 in the form of a child tax credit which acts to offset actual tax liability. The child tax credit is an addition to the dependency exemption and is available only to the parent entitled to claim the exemption.
An additional credit, the Child and Dependent Care Credit, is available to a custodial parent even if he or she waives the dependency exemption in favor of the other parent.
From a simple concept one hundred years ago to provide a source of revenue for the Federal Government by taxing income, federal tax law has steadily evolved and expanded. Despite periodic expressions of intentions to simplify the tax Code, it has grown ever more complex. Changes in tax law over the past fifty years have generally been modifications that are responsive to the needs of divorcing couples and their children. When considered as a whole, such changes have, almost without exception, been improvements.
Divorce lawyers have used their experience in applying the tax consequences of transactions incident to divorce into catalysts for change. The current state of the tax law as it applies to divorce remains a work in progress; however, it improves with each change.