Life is random, tax law isn’t.
By Robert S. Steinberg, Attorney, CPA, CVA (Florida)
Divorce Is Always Hard
Divorce as an emotionally taxing event that has been depicted often in literature and film. Most will think of the 1989 film, The War of the Roses (based on book of same name by Warren Adler), in which an ongoing vitriolic battle between Michael Douglas and Kathleen Turner turns self destructive. There is We Don’t Live Here Anymore, a 2004 movie by John Curran, based on the short stories We Don’t Live Here Anymore and Adultery by Andre Dubus (whose son is Andre Dubus III, House of Sand and Fog). There is Kramer vs. Kramer, the 1979 Academy Award winner with Dustin Hoffman and Meryl Streep, based on the book by Avery Corman. My favorite divorce book and movie, however, is The Accidental Tourist, novel by Anne Tyler. Marriage can end with anger, greed or the need for revenge but for William Hurt (Macon Leary) and Kathleen Turner (Sarah), far more subdued than in The War of the Roses, marriage ends with profound sadness, in loneliness and alienation. The two who love each other, both need but are unable to offer comfort to the other. They drift apart, Sarah unable to stop herself from blaming and Macon unable to start living again following an unbearable loss. Their son was shot and killed in a robbery. Sarah, a take charge person, believes that Macon “could have taken steps’ to prevent their son’s death. Macon, bearing some guilt, withdraws from life, writing a series of books for reluctant travelers called The Accidental Tourist. In a sense we are all accidental tourists subject to the whims of life’s exigencies. Macon’s life reignites accidentally with the help of a quirky, dog training woman (Geena Davis), with a young son, who draws him out of his shell. Read the book and learn why Anne Tyler is said to make one laugh and cry at the same time. That is also my regular reaction to reading the Internal Revenue Code.
Divorce When Times Are Hard
Divorce can also be financially taxing and the tax consequences, if not understood, will add to that distress. Fathoming the tax aspects of divorce becomes no less critical during economic hard times.
Property Transfers Between Spouses
We had become accustomed to thinking in terms of ever rising values of marital property with the inevitable built in gain and accrued tax liability. Section 1041(a) of the tax code mandates no gain or loss is recognized on transfers, whether by sale or otherwise, of property between spouses, or, in certain circumstances, former spouses. Instead, the tax basis carries over and the transferee spouse must pay the tax on the built in gain when he or she sells the property. The transfer is treated as a gift for all purposes under the tax code. In a depressed economy, however, the tax basis may exceed the fair market value of the property. Contrary to the general rule for gifts under Section 1015, transfers under Section 1041(a) will pass built in loss or negative basis to the transferee spouse. Business or investment losses on non-depreciable property will eventually be deductible in whole or part, when the property sold, unless the negative basis is erased by future appreciation. Depreciation, if permitted, will be based on the carryover basis, even if less than the fair market value on the date of transfer. A loss from the sale of a personal residence will not be deductible, however. In theory, the marital settlement agreement or court should address the value of future tax benefits to the same extent that local law would apply to a deferred tax liability. The holding period for capital gains will include the period held by the transferring spouse.
Delayed Transfers Between Former Spouses
Tough economic times often prolong the time required for executing settlement agreements. The marital home may not be currently salable at an acceptable price or at any price. Cash flow may be substantially reduced due to one or both spouses being out of work or a family business being in financial trouble. Stock options, although vested, may be out of the money. Section 1041 contemplates that transfers may be made after the divorce becomes final. Transfers made not more than one year following the divorce are covered by Section 1041(a) as being “incident to the divorce.” Beyond the one year period, transfers are covered if “related to the cessation of the marriage.” Temporary Treasury Regulations have taken a rather restrictive view treating as related to the cessation of the marriage only transfers contemplated by the divorce decree or marital settlement agreement and made within six years of the divorce. Clearly, a transaction, in which a former spouse, owing a building acquired in the divorce, decides ten years hence, to sell the building which his former spouse decides to buy, is an independent subsequent event, not a transfer related to the cessation of the marriage. I can envision circumstances beyond six years, however, where transfers would be related to the cessation of the marriage such as where a former spouse is given a right of first refusal to buy.
Not Covered By Tax Free Transfer Rule
Not every transfer incident to a divorce will be tax free under Section 1041. Some excluded transfers are:
- Transfers to third parties (not for the benefit of a spouse). Example: The court orders a property to be sold and the proceeds divided by the spouses. Gain will be recognized and must be reported by the record owner of the property. If only one spouse is on the title and both are to share the proceeds and tax liability, consider a pre-sale transfer into joint names that the tax liability reporting will be parallel to the proceeds division.
- Cancelation of Debt (COD) income on property transferred. COD income could be a big problem in the current economic climate. No loss will be recognized upon the inter-spousal transfer of property subject to a debt in excess of basis. But, if the debt is later cancelled or modified, the record owner will receive a Form 1099 regarding the debt cancelation. Debt forgiveness of home acquisition indebtedness may be tax free in whole or in part, however (see cancellation of debt issues below).
- Credit card debt assumed by one spouse and later compromised. If husband assumes the wife’s credit card debt and later settles the debts for ten cents on the dollar, the wife will receive a Form 1099 reporting COD income. The tax liability should be accounted for in the marital settlement agreement or by the court that the wife is not unfairly surprised with a tax liability not expected.
- IRA transfers between spouses are covered not by Section 1041(a) but by Section 408(d) (6). To be certain of qualifying for the exception to taxability the IRA transfer should be made pursuant to the divorce judgment and not be made under a separation agreement while the parties are still married.
- The transfer of Qualified Retirement Plans in divorce is governed by Section 414(p) and requires approval and entry of a Qualified Domestic Relations Order (QDRO). An ERISA tax lawyer should prepare the QDRO, with the assistance of an actuary for defined benefit plans.
- Non-statutory stock options are compensation taxed under Section 83. A transfer of a non-vested stock option, subject to substantial contingencies, in a divorce will not generate immediate income but when exercised, the transferor spouse will be charged with income equal to the value of the stock on the date of exercise in excess of the option exercise price. The transfer of vested options will, however, be tax free under Section 1041 and the recipient spouse will report the income when the options are exercised.
- Incentive Stock Options are taxed under the special rules in Code Sections 421 and 422.
Continued Joint Ownership Of Marital Home
The large number of homes listed and in foreclosure may make it difficult or impossible to sell the marital home. One spouse may not have sufficient other assets to buy out the spouse who is to live in the home with children. Thus, the former spouses may continue to own the home as tenants in common following the divorce. See Steinberg Talks Tax, Volume 3, No. 9 “Thinking about Taxes” for a discussion of tax deductions on jointly owned property.” The article is posted on my website.
Cancelation Of Debt (Cod) Income Issues
Some things to keep in mind:
- Cancelation of accrued interest which, if paid, would be deductible, does not generate COD income.
- Short sales and deed in lieu of foreclosure on recourse debt are treated as sales to the extent of the fair market value of the property transferred with excess debt treated as COD income.
- COD income will be realized when a loan is modified, cancelled, or becomes uncollectible by operation of law (running of stature of limitations). There is a limited exclusion for Home Mortgage Debt in Section 108(a)(1)(E) as enacted in the Mortgage Forgiveness Debt Relief Act of 2007 and amended by the Emergency Economic Stabilization Act of 2008 for qualified home mortgage indebtedness up to $2million for joint filers ($1 million for others), cancelled after January 1, 2007 and before January 1, 2013. The relief does not cover cash out mortgage debt or home equity lines and must have been on account of a decline in home value or deterioration of the taxpayer’s financial condition. Although the home’s tax basis is reduced by the COD income not recognized, the exclusion of gain from the principal residence later sold may moot the basis reduction. The decline in value may also be so severe that the adjusted basis is still greater than the selling price.
- Genuine disputes about the amount of the debt will reduce the amount of COD income to the adjusted amount due. Disputes over enforceability, however, do not impact the amount of COD income.
- Debts discharged do not generate COD income to the extent that the discharge does not render solvent an insolvent taxpayer. The solvency test applies to the spouse debtor of record but joint filers are jointly and severally liable for COD income not qualifying for the insolvency exception, unless one spouse qualifies for limited relief under so called Innocent Spouse Rules. The basis of assets must be reduced, under complex rules, by the amount of the COD income not taxed. A business owner spouse with COD income may have invisible value in intangible assets that renders him or her solvent, however.
Dealing With Tax Debts Asserted After Divorce
Following a divorce, it is too late to structure the settlement to save taxes, but even proposed additional taxes or assessed taxes can be reduced or eliminated at a number of key junctures in the tax process. These junctures generally involve areas more legal than accounting and should be handled by a tax lawyer, including:
- Appeal of an audit by filing a protest or filing a Petition in U.S. Tax Court. There are legal strategies that apply to the appeal process that take into consideration matters like choice of forum more legal than accounting.
- Filing a claim for refund to contest a penalty imposed on an alleged responsible person who failed to deposit withheld payroll taxes. Often the business spouse will name the other spouse as an officer of the business or even have him or her occasionally sign checks. The claim lays the legal and factual foundation for a refund suit in U.S. District Court.
- Filing Form 8857, Request for Innocent Spouse Relief. Don’t be fooled because the request is made on a tax form. This is a legal document, not an accounting process. A tax lawyer should be involved even though the Tax Court will admit additional evidence in its de novo review of the appeals process consideration. See my website for an article which had appeared in The Journal of the American Academy of Matrimonial Lawyers, on innocent spouse defenses.
- Requesting a Collection Due Process Hearing. When IRS has recorded its federal tax lien or threatened to levy on assets, under mistaken facts or without considering more appropriate collection measures, consider having your tax lawyer file, taking into consideration, among other legal considerations, the impact of filing on collection statute of limitations and bankruptcy waiting periods. Under no circumstances make a request that is frivolous, that is, lacking serious legal grounds for objection to the action taken.
In the last scenes of “The Accidental Tourist” Macon says to Sarah, “I’m beginning to think it’s not just how much you love someone. Maybe what matters, is who you are when you’re with them…It’s wrong to think we can plan everything as though it were a business trip. I don’t believe that anymore. Things just happen.”
If life is random, tax law is not. Usually, bad things happen to taxpayers, when they make bad decisions, or, a mistake in how they interact with the tax system hierarchy. Typically, it starts with one’s filing a foolish or careless return; but, trouble can also emanate from false or careless statements made to a Revenue Agent (IRS auditor) or Revenue Officer (IRS collection agent). When people are under financial stress they are more likely to make the kinds of miscalculations that lead to tax and financial disaster. I try to help my clients maintain their wits and keep their balance. No one falls off a roof when he or she is standing in the street.
Originally published in the author’s e-newsletter Steinberg Talks Tax (TM) VOL 4, NO 4 (May 25, 2010)
Copyright 2010 by Robert S. Steinberg, All rights reserved. Reprint with permission.
Robert Steinberg represents clients in criminal and civil tax disputes and offers tax planning services and business advice based on his 45 years of experience. He also assists clients with credit repair and general business advice and has written and spoken extensively on diverse tax matters as well as on general business and investment risk and decision-making.