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Internal Revenue Section Code 1041
Internal Revenue Section Code 1041
With April 15th fast approaching, we, like many of you, are turning our attention to taxes. For couples contemplating a divorce or in the process of a divorce one of the most important tax provisions to be aware of is Internal Revenue Code section 1041 which addresses the transfer of property between spouses or former spouses. This section provides that any transfer of property from one spouse to another is a nontaxable event. This means that no deductible loss or taxable gain is declared on a qualifying transfer. This section applies to transfers during marriage as well as during divorce. Section 1041 was part of reforms intended to simplify the Internal Revenue Code.
Before 1984, the federal court case of United States v. Davis held that a transfer of property from one spouse to another, "incident to a divorce," or property settlement was an event for recognition of gain or loss to the transferor. In determining the gain or loss to be applied, the Internal Revenue Service would look at the fair market value of an asset at the time of the transfer as compared to its taxable basis, usually the cost to acquire the asset with certain permissible adjustments for either depreciation or improvements. In 1984 the Internal Revenue Code was amended to provide that gain or loss will be recognized on transfers of property between spouses or between former spouses "incident to a divorce." (lifemanagement.com) Section 1041 was the key component of this amendment.
The Bradford Tax Institute defines the rule as:
(a) General rule
No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of)—
(1) A spouse, or
(2) A former spouse, but only if the transfer is incident to the divorce.
(b) Transfer treated as gift; transferee has transferor’s basis
In the case of any transfer of property described in subsection (a)—
(1) For purposes of this subtitle, the property shall be treated as acquired by the transferee by gift, and
(2) The basis of the transferee in the property shall be the adjusted basis of the transferor.
(c) Incident to divorce
For purposes of subsection (a)(2), a transfer of property is incident to the divorce if such transfer—
(1) Occurs within 1 year after the date on which the marriage ceases, or
(2) Is related to the cessation of the marriage.
(d) Special rule where spouse is nonresident alien
Subsection (a) shall not apply if the spouse (or former spouse) of the individual making the transfer is a nonresident alien.
(e) Transfers in trust where liability exceeds basis
Subsection (a) shall not apply to the transfer of property in trust to the extent that—
(1) The sum of the amount of the liabilities assumed, plus the amount of the liabilities to which the property is subject, exceeds
(2) The total of the adjusted basis of the property transferred.
Proper adjustment shall be made under subsection (b) in the basis of the transferee in such property to take into account gain recognized by reason of the preceding sentence.
What Does This Mean?
Section 1041 as amended in 1984 is not limited to transfers of property incident to divorce. Section 1041 applies to any transfer of property between spouses, regardless of whether the transfer is a gift or is a sale. A divorce or legal separation must not be started between the spouses at the time of the transfer.
Example 1: A and B are married and file a joint return. A is the sole owner of a home. A sale or gift of the home from A to B is a transfer subject to the rules of 1041.
Example 2: A and B are married and file separate returns. A is the sole owner of an independent X Company. In the ordinary course of business, X Company makes a sale of property to B. This sale is a transfer of property between spouses and is subject to the rules of 1041.
Only transfers of property are governed by 1041. Transfers of services are not subject to the rules of 1041.
The property transferred to a former spouse cannot have been owned by the transferor spouse during the marriage (law.cornell.edu).
A transfer of property is "incident to the divorce" in either of the following two circumstances:
(a) The transfer occurs not more than a year after the date on which the marriage ceases.
(b) The transfer is related to the termination of the marriage.
(1) Transfers are presumed related to divorce if made pursuant to a Marital Settlement Agreement, Stipulated Judgment or Court Order (or any modification of an agreement, judgment or order) and occur within 6 years of the termination of the marriage. Transfers occurring more than 6 years after the marriage are presumed not to be related to the termination of the marriage. (lifemanagement.com)
The transferor of property under 1041 does not see any gain or loss on the transfer, even if the transfer was in exchange for the release of marital rights or other consideration.
The transferee of property does not recognize a gain or loss upon receipt of the transferred property. However, the transferee may have built in gains or losses as the transferee assumes the transferor’s adjusted tax basis as of the time of the transfer. Even in the event of a bona vide sale (i.e. the purchase of a spouse’s equity in a home at fair market value) the transferee does not acquire a tax basis equal to the fair market value paid. This rule applies to both gains and losses and is usual most relevant on a subsequent sale or transfer of the property constituting a recognition event for tax purposes. (law.cornell.edu)
A transfer under 1041 may result in the bringing back of investment tax credits with respect to the property transferred. If the property, for example a car, being transferred is used for solely personal use, then the transferee is subject to recapture of the investment tax credit previously taken by the transferor.
Understanding the tax effects of a divorce or marriage can be complicated. It is important to address these issues with knowledgeable counsel. If you have any questions regarding Internal Revenue Section Code 1041 or other tax implications associated with a divorce, please contact The Law Office of Matthew J. Rudy for a free 1-Hour Consultation.