Podcast Summary: How Tax Works – Tax Issues with Divorce

Host: Matthew Foreman, Co-Chair, Falcon Rappaport & Berkman Taxation Practice
Date: December 16, 2024
Episode: 15

Overview

In this episode, host Matthew Foreman deeply unpacks the tax complexities surrounding divorce in the United States, focusing heavily on property transfers, alimony, and child support from a tax law perspective. The conversation is technical yet accessible, filled with actionable advice, real-life examples, and Matthew’s signature direct, sometimes wry, tone. Whether you’re a tax professional, legal advisor, or anyone facing divorce, this episode illuminates the intricate relationship between personal separations and tax consequences.

Key Discussion Points & Insights

1. The Fundamentals: Section 1041 and Property Transfers

• Historical Context and Main Rule (02:00–04:00):

  • Prior to 1984, transfers of property as part of divorce could trigger taxable events, making a difficult situation harder. The Deficit Restoration Act of 1984 added Internal Revenue Code (IRC) Section 1041, clarifying that property transfers between spouses (including green card holders, not just citizens) as part of a divorce are generally tax-free.
  • "If you can do unlimited spousal gifting, why are we making them do weird gifting before they divorce? ... Let's just have one less thing for people who are already fighting." – Matthew Foreman (03:10)

• Tax Deferral, Not Tax Elimination:

  • These 'tax-free' transactions are actually tax deferrals—gain or loss is triggered only on a future sale/disposition, not at the moment of transfer.

• State Taxes and Decoupling:

  • While federal law dictates non-taxability, states could potentially “decouple,” though Matt notes he’s unaware of any that actually do.

• Valuation and Tax Burden Nuance:

  • The value of property in divorce isn’t just its fair market value—it’s the FMV minus likely tax burden.
    • “You want to maximize the fair market value, the value of the property, less the tax that will be due, right? That's the maximization.” (03:37)

2. Instruments and Timing (06:14–08:49)

• What Constitutes a Divorce or Separation Instrument:

  • Can be formal (court judgments, decrees) or informal (emails, letters) if they clearly show intent.
  • Religious court decrees may potentially work, as long as intent and documentation are clear.

• Critical Role of Intent:

  • The parties must intend the transfer to qualify for 1041 treatment, as inferred from actions and communications.

3. Alimony and Child Support Nuances (08:49–14:11)

• Pre-2019 vs. Post-2019 Rules (Tax Cuts and Jobs Act):

  • Prior to 2019, alimony payments were deductible for the payer and taxable income for the recipient.
  • Post-2019, neither deductible nor taxable, unless the divorce or separation instrument predates 2019 and isn’t modified.
    • “Section 71 was repealed, but that doesn't mean it's not effective anymore. It still kind of exists for agreements from before.” (11:12)
  • There's regulatory and practical murkiness around agreements involving pre-2019 pre- or post-nuptial agreements but finalized post-2018.

• Alimony Definition and Compliance:

  • Payments made on behalf of the ex, such as legal fees or housing, may count as alimony.
  • Alimony is only possible if a couple is or was legally married, not just religiously so.

• Child Support:

  • Never deductible, never income. Do not try to disguise child support as alimony—IRS rules can reclassify such payments on audit.

4. Special Cases: Non-Resident Spouses and Trust Transfers (14:11–17:17)

• Non-Resident Alien Spouses:

  • If either spouse is a non-resident alien, property transfers may be taxable (not protected by 1041).

• Trust Transfers and Liabilities:

  • Gain can be recognized if property is transferred to a trust and liabilities exceed basis, or if certain encumbrances exist.

5. Timing and “Incident to Divorce” Requirements (17:17–20:55)

• Crucial Timing Windows:

  • To qualify for 1041 treatment, transfers must occur within one year after divorce or relate to the termination of the marriage (up to six years, with certain rebuttable presumptions if beyond that).

• Practical Example:

  • If transfer delayed beyond six years (e.g., because of unforeseen issues like environmental remediation), 1041 treatment can potentially still apply, but expect scrutiny.

6. Business Interests and Special Assets (20:55–22:47)

• Business Ownership:
  • Special rules (Treas. Reg. 1.1041-2) apply when redeeming stock from a jointly owned company—tax impact can be complex and may not be as intended.
  • If a buyout involves a third party, special care is needed regarding attribution of income and basis.

7. Assignment of Income and Stock Options (22:47–25:42)

• Income Assignment Limitations:

  • Can't assign a right to future income, but you can assign the underlying property producing it.
  • Notable case: Lucas v. Earl—characterizes assignment of income doctrine.

• Stock Options:

  • Transfer of Non-Qualified Stock Options (NSOs) can be covered under 1041; Incentive Stock Options (ISOs) generally cannot be transferred.

• Marital Home Nuances:

  • Watch for section 121 home sale exclusions or, bizarrely, loss of the first-time home buyer credit on transfer.

8. Children, Credits, and Filing Status (25:42–27:16)

• Child Tax Credits & EITC:

  • Only one parent can claim them; allocation affects support calculations and must be handled carefully in agreements.

• Filing Status Post-Separation:

  • Head of household vs. single—varies by custodianship and legal status.
  • It's possible to file as single if abandoned and unable to serve the other spouse, even if no divorce decree.

• Innocent Spouse Relief:

  • Tough to obtain; you must have been unaware of tax issues and not benefited from disputed income.

9. Key Guidance For Divorcing Parties (Throughout)

• Bring in Experts:
  • “This is a situation where you really, really, really, really, really want to have an expert and have someone who thinks about these things and goes through it.” (04:07)
• Scrupulous, Clear Drafting:
  • “Clear drafting. Say what you're doing. Don't hide, don't try to dilly dally, don't try to be cute.” (27:18)

Notable Quotes & Memorable Moments

• On prioritizing practicality over perfection:

  • “Don't let the tax tail wag the dog. This is life. A lot of times there's kids involved. ... Legal fees often eat up, you know, more than the benefit anyway.” (05:15)

• On clarity in agreements:

  • “Pre and post nuptial agreements should be clear. ... It's like anyone tells you for good writing, right? Say what you're going to do. Do it. Say what you did.” (27:18)

• On compliance and expert advice:

  • “Some courts will just entirely ignore, right, the tax consequences when determining the equitable division of assets. So get, get an expert, get someone to come in and look at it.” (04:19)

Timestamps for Important Segments

• [02:00] – History and Spirit of Section 1041
• [04:35] – Tax Basis Example: Asset Value Versus Tax after Sale
• [06:14] – What Counts as a “Divorce or Separation Instrument”
• [08:49] – Alimony Pre- vs. Post-2019, Deductibility, and “Excess Alimony”
• [14:46] – 1041: Unlimited Gifting, Nonresident Alien Spouses
• [17:17] – Property Transfer Timing Rules (One Year/Six Year Windows)
• [20:55] – Corporate/Business Asset Divisions in Divorce
• [22:47] – Assignment of Income and Stock Option Transfers
• [25:42] – Children: Credits and Deductions Post-Divorce
• [27:16] – Key Summary and Takeaways

Final Takeaways

• For lawyers, accountants, and divorcing spouses, understanding the tax status of transfers, alimony, child support, and special assets is vital—federal rules (1041, 121, 71, etc.) provide a framework but leave room for pitfalls.
• Precise drafting in all separation-related documents is indispensable, as are proactive conversations about tax positions.
• Don’t let tax optimization override practical, humane resolution—especially when children or ongoing relationships are involved.
• When in doubt, involve a tax expert—ideally before finalizing any transactions or agreements.

For further reading:
Listeners are encouraged to consult the official IRS guides on divorce-related tax matters, and, as Matt consistently reiterates: hire your own attorney or tax professional before acting.