Property Settlements

A separation or divorce almost always involves a transfer of cash or other property between the spouses. When the transfer is in the form of cash, the initial determination is whether the payment represents alimony, child support, or a property settlement. If the cash payment (or property transfer) is treated as a property settlement, the payor spouse cannot deduct the payment and the payee spouse does not include any amount in income. As a general rule, if a payment meets the requirements of alimony (as discussed in ¶1310.01.A, above) and is not fixed as child support, then it is characterized as alimony. If the payment is not alimony or child support, then it is characterized as a property settlement.

In categorizing a payment as being in the nature of alimony and child support, on the one hand, or a property settlement, on the other hand, the courts are divided as to whether the labels used by the parties are determinative. Some courts hold that the labels used are not determinative. These courts insist that the facts and circumstances surrounding the divorce determine whether a payment is truly of the type that the parties allege, at least where: (1) the divorce decree is not based on a contested hearing and merely incorporates the parties' marital dissolution agreement; and (2) the dissolution agreement is ambiguous as to the parties' intent. 75 Hence, a payment that the parties have labeled as alimony (or child support) in a marital dissolution agreement may be recharacterized as being in the nature of a property settlement. 76 Other courts take a contrary view, however, holding that the parties have considerable freedom in determining the tax consequences of their divorce through a negotiated property settlement agreement. 77

/Footnote/ 75 E.g., Steen v. Comr., T.C. Memo 1989-542, aff'd, 91-1 USTC ¶50,062 (8th Cir. 1991).

/Footnote/ 76 Id.

/Footnote/ 77 E.g., Boucher v. Comr., 710 F.2d 506 (9th Cir. 1983); Bernstein v. Comr., 662 F.2d 442 (9th Cir. 1980).

A transfer of property can never qualify as alimony because of the requirement that alimony be paid only in cash. 78 Further, if appreciated property is transferred under a divorce or separation instrument the question arises whether the transferor spouse must recognize gain equal to the appreciation in the value of the transferred property. Briefly, and as discussed more fully below, the transferor is not required to recognize any gain.

/Footnote/ 78 §71(b)(1).

A property settlement is a broad category covering all manner of transfers such as gifts of cash or property, a sale or purchase of property for cash, exchanges of property (whether they be tangible or intangible assets) and divisions of property among co-owners. If the property settlement is a transfer between spouses, 79 or a transfer between former spouses that is incident to a divorce, 80 the property settlement transfer is governed by special rules. These special rules provide that no gain or loss is recognized on such transfer. 81 Further, all such transfers are treated as gifts. 82 Since no gain or loss is recognized on the transfer, the transferred assets retain the same basis in the hands of the transferee as they had before the transfer took place. 83 If the special rules do not apply to the transfer, then general income tax principles govern and gain may be recognized if the asset transferred has appreciated in value. As stated above, the special rules 84 are extremely broad in scope. They cover most transfers between spouses, whether during marriage or after cessation of marriage (whether or not pursuant to a separation or divorce instrument) and whether direct or indirect (i.e., in trust for the benefit of the transferor's spouse).

/Footnote/ 79 §1041(a)(1).

/Footnote/ 80 §1041(a)(2).

/Footnote/ 81 §1041(a). The nonrecognition treatment provided by §1041(a) overrules the result reached in U.S. v. Davis, 370 U.S. 65 (1962), and is generally effective for all covered transfers of property after July 18, 1984. Before the effective date of §1041, a property settlement transfer of appreciated property made pursuant to divorce or separation and made in exchange for the relinquishment of marital rights by the spouse receiving the property resulted in gain to the transferor on the theory that he sold the appreciated property for marital rights equal in value to the property transferred. The measure of the gain was the difference between the fair market value of the property and its adjusted basis. See also Yonadi v. Comr., 94-1 USTC ¶50,183 (3d Cir. 1994), rev'g T.C. Memo 1992-602.

/Footnote/ 82 §1041(b)(1). See Balding v. Comr., 98 T.C. 368 (1992), where the court held that settlement payments received from ex-husband in consideration of wife's release of any claim to community property share of husband's military retirement benefits was a nontaxable gift, excludible from her gross income. Note, however, that §1041 does not determine the taxability of interest on indebtedness incident to divorce. See Seymour v. Comr., 109 T.C. No. 14 (11/5/97).

/Footnote/ 83 §1041(b)(2).