Income taxation of property transfers between spousesSeptember 30, 2012 - Phil HodgenAmericans Living Abroad, Speeches, Publications, and Events
I will be speaking on November 1, 2012 (Los Angeles) and November 2, 2012 (San Francisco and simulcast on the internet) at the 2012 Family Law Conference of the California Society of Certified Public Accountants.
Here, for your reading pleasure, is a portion of the presentation materials. This is installment four in a series of five. Like the others, this version of the handout has all of the footnotes stripped out of it. Sorry. You’ll have to show up in person to get the handout in all of its PDF glory.
Property Transfers Between Spouses: Income Tax
Property transfers to nonresident alien spouses or former spouses will trigger recognition of gain or loss. The normal “no income tax, no problem” approach toward property settlements will not work.
Any property transfer involving a noncitizen spouse or former spouse must also run the gauntlet of the gift tax rules. Transfers to noncitizen spouses are not afforded the full exemption from gift tax that citizen spouses expect. Just avoiding the tax pitfalls discussed in this chapter will not be enough. Look at the gift tax chapter as well.
The Normal Income Tax Rules
Everyone knows what to expect for property settlements in a divorce, even cocktail party tax advisors: no gain or loss is recognized in a transfer of property between spouses. Similarly, no gain or loss is recognized for a transfer of property between former spouses, if the transfer is incident to divorce.
As long as the technical rules are satisfied (mostly related to that magic phrase “incident to divorce”), the person making the transfer does not create a taxable gain or loss, and the person receiving the property takes the adjusted basis of the transferor.
Transferee is a nonresident alien
The normal rules do not apply if the spouse (or former spouse) receiving the property is a nonresident alien. The explicit nonrecognition provision of Section 1041(a) does not apply, in other words, to transfers to a person who is a “nonresident alien.”
Someone who was a nonresident alien (i.e., not a resident and not a citizen of the United States) last year and who commences living in the United States in the current year can elect to be treated as a resident alien starting on January 1 of that first year of residency. This is done by making an election.
It would be a truly exceptional divorce that would involve property transfers incident to a divorce occurring in the first year that the recipient became a resident of the United States. However, for normal transfers between married couples, this happens more commonly. A married couple that immigrates to the United States should time interspousal transfers carefully–especially for appreciated property. Transfers that occur while both are nonresidents are obviously safe. The IRS cannot touch transactions between nonresidents involving non-U.S. property. But transfers of U.S. property, or transfers that involve one resident and one nonresident spouse, may be tripped up inadvertently by the application (or not) of the nonrecognition rules of Section 1041(a).
Transfer to Green Card Holder
If the transferee spouse holds a green card, it does not matter where in the world he or she lives. A transfer of property incident to divorce will be covered under the normal rules of Section 1041(a). No gain or loss is recognized.
This result occurs because Section 1041(d) says that transfers to nonresident aliens are not covered by the normal nonrecognition rules that apply to transfers between spouses and former spouses. Note, however, that the transferor may not be up-to-date on a former spouse’s actions with respect to green card status. The normal rules apply if the recipient still has a green card. But if the recipient has terminated green card status without notifying the transferor, painful income tax results might apply: the transfer will trigger gain or loss, because Section 1041(d) will now override the normal rules of Section 1041(a).
Check the recipient’s visa status before making the property transfer.
Transfer to Resident under Substantial Presence Test
The substantial presence test is a year-by-year test. Each tax year the days of presence in the United States will be checked for the current year and the two prior years. The appropriate arithmetic is done, and the result will make the taxpayer a resident or nonresident of the United States.
For the transferor, this creates a risk that is not within his or her control. A transfer to a spouse or former spouse who is a nonresident under the “count the days” methodology of the substantial presence test will be treated as a taxable event.
If the recipient spouse or former spouse is a noncitizen and does not hold a green card visa, the transferor would be wise to make property transfers only in tax years where the recipient is a resident alien under the substantial presence test rules. This makes the transfer qualify for nonrecognition under the normal rules of Section 1041(a).
On the other hand, it might be useful to cause a property transfer to be treated as a taxable event. Perhaps it is useful, for instance, to recognize a capital loss. In that case the property transfer would not be treated as qualifying for the nonrecognition treatment of the normal rule at Section 1041(a). It would be taxable for income tax purposes.