What taxation rules should I consider when structuring my divorce propery settlement?

When divorcing and structuring your property settlement, there are important tax considerations to keep in mind.

Internal Revenue Code section 1041 provides guidance on the taxation of transfers of property between spouses.  The general rule states that property transfers between divorcing spouses are treated as tax-free gifts and no gain or loss on the transfer occurs if the transfer is a result of the divorce.  A transfer is considered a result of a divorce if one of two following conditions applies:

1. The transfer occurs within one year after the date on which the marriage ceases (the date on which the marriage ceases is determined by your state law) or
2. Is related to the cessation of you marriage (a divorce for this purpose, includes the ending of your marriage due to violations of state laws or an annulment)
   

The second point needs some additional clarification.  In order to be related to the cessation of your marriage, the property transfer must meet the following conditions:

1. The transfer is made due to instructions within your original or modified divorce or separation instrument, and
2. The transfer occurs with six years after the date your marriage ends (the date on which the marriage ceases is determined by your state law)

Transfers that are made incident to divorce are considered tax-free according to Internal Revenue Code section 1041(a) and the tax treatment is considered mandatory and not elective.

An exception to the above rule exists and is something that you should be aware of.  Property transfer will be taxable if one of the exceptions applies:

• Your spouse or former spouse is a nonresident alien
• Transfers in trust in certain situations
• Certain stock redemptions

Also, the non-recognition rule is limited to transfers of property, and does not address income.  The Internal revenue Service in previous rulings has stated that assignments of income (interest income from US savings bonds) do not constitute and transfer of property.

The definition of property that qualifies for the non-recognition of taxes (leading to a tax-free transfer) includes the following:

• Real property (real estate)
• Personal property (furnishings, auto, etc.)
• Tangible or intangible (patents, copyrights, etc) property
• Separate or community property
• Property acquired after the end of your marriage and transferred to your former spouse

Make sure you consider how the decisions you are making during your divorce will impact you at the end of the year.