Transfers of Property Incident to Divorce

Transfers of Property Incident to Divorce

In general, no gain or loss is recognized when property is transferred between spouses or between former spouses if the transfer is incident to divorce. When this nonrecognition rule applies, the receiving spouse (transferee) is treated as acquiring the property by gift. As a result, the transferee’s basis in the property is the same as the transferor’s adjusted basis at the time of transfer.

A transfer is considered “incident to divorce” if:

  1. It occurs within one year after the divorce is finalized, or
  2. It is related to the divorce, meaning it is made under a divorce or separation agreement and occurs within six years after the divorce.

Exceptions to the Nonrecognition Rule:

  • The rule does not apply if the transferee spouse is a nonresident alien.
  • It also does not apply to property transferred in trust if the liabilities assumed (or attached to the property) exceed the property’s adjusted basis. In such cases, the transferee spouse must adjust the basis to reflect any recognized gain.

Stock Redemptions in Divorce: The tax treatment of a stock redemption depends on whether the receiving spouse is considered, under tax law, to have received a constructive distribution when the other spouse receives property for the redeemed stock. This can happen, for example, when the transferee spouse is under a binding obligation to buy the shares.

Two scenarios apply:

  1. Constructive Distribution Applies:
    If the transaction is treated as a constructive distribution to the transferee spouse:

    • The transferor is deemed to first transfer the stock to the transferee spouse, who then transfers it to the corporation.
    • Similarly, any property the transferor receives from the corporation is deemed to pass first to the transferee spouse, and then to the transferor.
    • The nonrecognition rule applies to transfers between spouses but not to transfers between the transferee spouse and the corporation.
  2. Constructive Distribution Does Not Apply:
    If the transaction is not treated as a constructive distribution, the transferor is treated as having received a distribution from the corporation in redemption of stock. In this case, the nonrecognition rule does not apply.

Binding Agreements Override Tax Law Treatment:
If a divorce or separation agreement (or any other valid written agreement between the spouses) explicitly states how the redemption should be treated, that stated intent controls:

  • If the spouses agree it should be treated as a constructive distribution to the transferee, then treatment (1) applies.
  • If they agree it should be treated as a distribution to the transferor, then treatment (2) applies—regardless of what tax law would otherwise dictate.