Property Transfers Between Spouses: Gift Tax
Section 1041(b) generally makes transfers to nonresident spouses subject to income tax gain or loss recognition. That is not the only problem that applies to transfers between spouses or former spouses when the international gift tax rules start to apply.
The normal rules that everyone expects to see for transfers between spouses and former spouses are benign. Assume a typical divorce where both spouses are U.S. citizens.
A transfer within the scope of Section 1041 is treated as a gift for income tax purposes. That is how the income tax rules cause such a transfer to escape gain or loss recognition, and to cause the recipient to have the giver’s basis.
The Normal Gift Tax Rules
At the same time, Section 2501(a)(1) imposes a tax on transfers of property by gift. It is sufficiently broad that it would apply to transfers between spouses and former spouses. However, there are a number of exceptions that can be used to reduce or eliminate the gift tax on interspousal transfers, either while the couple is married or incident to a divorce.
The biggest one–and easiest to rely on in the purely domestic context–is the unlimited gift tax marital deduction. Look at your total gifts for the year. Deduct from that any transfers to your spouse. What remains will be your taxable gifts. For married couples this rule means that there is no gift tax, ever, on interspousal transfers.
This is true even in the divorce context. Transfers of property and payments of cash between divorcing or divorced spouses will be exempt from gift tax if made pursuant to a written settlement agreement and made within a defined time period.
Coupled with Section 1041(a), which causes such transfers to be nonrecognition events for income tax purposes, spouses and former spouses have the assurance that asset transfers between themselves will always be tax-free. Income tax and gift tax? Both eliminated.
International Gift Tax Rules: Income tax (resident aliens) vs. gift tax (citizens)
Whether gain or loss is recognized in interspousal transfers–during marriage or as part of a divorce–depends on the recipient’s status as a resident alien. If the recipient is a resident alien, no gain or loss is recognized on the property transfer; if the recipient is a nonresident alien, gain or loss will be recognized.
Citizenship does not enter into the picture for income tax purposes. If the recipient spouse is a U.S. citizen, then the property transfer will be a nonrecognition event, no matter where the recipient lives on the planet.
The gift tax problem, however, revolves around citizenship. The recipient can be a resident alien, and gift tax will still apply to the property transfers. This means a green card holder or a person who is a resident alien because of the substantial presence test (too many days in the USA) cannot receive property transfers from his or her spouse (during marriage or incident to a divorce) without triggering a possible gift tax liability for the donor.
Gift tax when the recipient is a noncitizen
When the recipient spouse is not a U.S. citizen, the unlimited federal gift tax marital deduction does not apply. Instead of the unlimited marital deduction, gifts to noncitizen spouses have a large annual exclusion. The amount is indexed annually for inflation. For 2012, the amount that can be given to a noncitizen spouse tax-free is $139,000.
This means that every property settlement where the transferee is a noncitizen must be scrutinized for potential gift tax liability for the donor.
But more important, this same rule applies even to a couple that never gets divorced. If the recipient is not a U.S. citizen, the unlimited marital deduction does not exist.
Husband is a U.S. citizen and Wife is a green card holder. They live in the United States. Husband gives Wife 50% of a piece of real estate that he owns. The value of the interest in real estate is $500,000.
Husband has made a taxable gift to his wife. The first $139,000 of the gift is exempt from gift tax. The remainder ($361,000) is subject to gift tax.
Income tax or gift tax?
Property settlements between spouses may trigger gain recognition if the transfer is a “sale or exchange”. Alternatively, they may trigger gift tax if the transfer is a gift. It won’t be both. A gift is a gratuitous transfer, with nothing received in return. Property transfers where he gets this asset and she gets that asset will be a sale or exchange.
Recipient is a U.S. taxpayer
If the recipient of a property transfer that is treated as a gift is a U.S. taxpayer (a citizen or resident alien), he or she must report the gift from a nonresident alien on Form 3520 if the value is over $100,000.
Husband is a nonresident alien. Wife is a U.S. citizen. Husband makes a property transfer to Wife of $500,000 cash. Wife must report the receipt of that gift on Form 3520.
I hope this was helpful. If this doesn’t exactly apply to your situation, feel free to contact us, and we’ll point you in the right direction.