Prior to the Tax Cuts and Jobs Act of 2017, transfers between spouses or former spouses incident to divorce were treated as either (a) nontaxable transfers under Section 1041 or (b) alimony or separate maintenance payments under Section 71. Under that prior regime, alimony payments under Section 71 were included in the taxable income of the recipient and resulted in an income tax deduction for the payor. The 2017 Act repealed Section 71 and its corollaries, Sections 62(a)(10) and 215, which provided the deduction for the payor of alimony. Although most states follow the current Internal Revenue Code, some do not. Accordingly, in some states, alimony is still taxable to the recipient and deductible by the payor for state income tax purposes.

Although Section 71 is repealed, Section 1041 remains intact. Section 1041(a) provides no gain or loss is recognized on a transfer of property from an individual to (or in trust for the benefit of) (i) a spouse, or (ii) a former spouse but only if the transfer is incident to divorce. Section 1041(b) provides “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.” The effect of treating a transfer as a gift for income tax purposes is the application of Section 102, which excludes the value of gifted property from the gross income of the recipient. Section 1041(c) provides that “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.” Section 1041(d) provides subsection (a) does not apply if the spouse (or former spouse) of the individual making the transfer is a nonresident alien of the United States.

Temporary regulations under Section 1041(c)(2) clarify that a transfer of property between former spouses is deemed related to the cessation of marriage under Section 1041(c)(2) if (i) the transfer is pursuant to a divorce or separation instrument, and (ii) the transfer occurs not more than six years after the date on which the marriage ceases. Treas. Reg. § 1.1041-1T(b), Q&A-7. Any transfer made more than six years after the cessation of the marriage and any transfer not pursuant to a divorce or separation instrument is presumed non-divorce related. However, the presumption is rebuttable where it is shown the transfer was made to effect the division of property owned by the former spouses at the time of divorce.

Any interest paid in connection with late transfers between a spouse or former spouse incident to divorce is not exempt from tax. Gibbs v. Commissioner, T.C. Memo 1997-196. Similarly, Seymour v. Commissioner, 109 T.C. 279 (1997), establishes interest paid to a spouse or former spouse incident to divorce gives rise to a deduction to the extent it is allocable to a deductible expense.

John G. Hodnette is an attorney with Fox Rothschild, LLP in Charlotte.

May 14, 2024/by TAX