Tax Issues Facing Federal Employees Who Divorce — Part I: Dividing Income and Deductions

As employees gather their income documents in order to start preparing their 2019 federal and state income tax returns, federal employees have to make decisions with respect to their income and deductions.

One particular group of employees will be further challenged as they gather and evaluate their income and deduction information. These federal employees are those who were married prior to 2019 but divorced during 2019. In a series of two columns discussing tax issues facing federal employees who divorced during 2019, this column discusses dividing up income and deductions between spouses who divorced during 2019.

Upon the dissolution of a marriage, for tax purposes former spouses can no longer file a joint income tax return starting in the year they officially divorced. For the year they divorced, they must divide up their income and deductions on their individual tax returns. The rules governing the division of income and deductions differ significantly between community property states and equitable distribution states. The following states are community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. All other states are equitable distributions states. The rules for dividing up income and deductions in the two types of states are now discussed.

Community Property States

The community property laws of the state where the couple is domiciled is the starting point for determining community income and deductions. In some states, the community property laws start when the couple marries and terminates when the marriage ends. But in some states the community property laws terminate before that, such as in the month of separation. The basic concept of community property law is that both spouses own property acquired during the community equally.

• Separate property. The rules for property owned by a spouse before the marriage and property acquired by gift or bequest vary from state to state. In some community property states, property acquired by gift or inheritance remains separate property. Depending on the state, separate property can also include property purchased with separate funds.

• Community property. Community property is generally all property acquired by either spouse during the marriage (or until the community is deemed terminated) other than separate property. Property acquired during marriage includes a spouse’s earned income (salaries, wages and self-employment income). Income generated by community assets (interest or rents) is also community income.

Income from Community Property

In community property states, former spouses must report their share of community income and deductions up to the time the community property rules end and their separate income and deductions for the remainder of the year.

This means that the tax year consists of two periods; namely: (1) the period from the beginning of the tax year (Jan. 1) through the day of divorce; and (2) the period beginning with the divorce date and ending on the final day of the tax year (Dec. 31). The income from these two periods is added together for determining each spouse’s taxable income for the year. There are exceptions to the general rule for dividing community income. Affected employees should check with a tax professional in their community property state in order to determine if they qualify for an exception.

Equitable Distribution States – Rules for Dividing Between Spouses

For divorced spouses living in equitable distribution states, the following table summarizes the treatment of table income and tax deductions:

Property Transfers Related to Divorce

Internal Revenue Code (IRC) Section 1041 governs the tax consequences of property transfers between spouses or former spouses that are “incident to a divorce”. IRC Section 1041 generally provides that: (1) No gain or loss is recognized by either spouse; and (2) the tax basis and holding period of the property transfer with the property. The following example illustrates:

David and Deborah are divorcing. David owns a piece of real estate as separate property. The real estate has an adjusted basis of $120,000 and fair market value of $250,000. David transfers the real estate to Deborah in exchange for a release of Deborah’s marital rights including the right to alimony. Neither David nor Deborah recognizes any gain or loss on the transfer. Deborah’s basis in the real estate is $120,000.

Note the following with respect to IRC Section 1041:

• IRC Section 1041 is mandatory whenever property is transferred between spouses or between former spouses, incident to a divorce. Divorcing spouses cannot opt out of IRC Section 1041.

• There is no gain or loss on the transfer even if one spouse pays cash to the other spouse for the property.

• IRC Section 1041 rule applies whether the transfer is of separately owned property or a division of marital property.

What is “Incident to a Divorce”?

A transfer of property is incident to a divorce if either of the following conditions exists: (1) The transfer occurs within one year after the date the marriage ends; or (2) the transfer is related to the ending of the marriage. In particular:

• Transfer within one year of divorce. Any property transferred between former spouses within one year of the date of a divorce or separation is final (as determined by state law) is presumed to be incident to the divorce. The transfer need not be required by divorce or separation agreement. If the transfer is within one year of the divorce, IRC Section 1041 applies, even to property acquired after the divorce. The following example illustrates:

Allen and Paula were divorced on Aug. 31, 2019. In October 2019, Allen bought 100 shares of ABC Company stock for $30,000. On Dec. 9, 2019, Allen transfers the ABC stock, worth $32,000, to Paula in exchange for her release of right to $28,000 of alimony. The payment is not considered alimony since it was not made in cash. The transfer is, however, tax-free under IRC Section 1041 since it occurred within one year of divorce. 

• Transfer related to the ending of the marriage. A property transfer made pursuant to a divorce or separation instrument within six years after the date the marriage ends is presumed to be related to the end of the marriage. Unlike transfers made within one year after a divorce becomes final which in most states are tax-free, transfers during years two through six after a divorce are final but must be made pursuant to a divorce or separation instrument in order to qualify for tax-free treatment. The following example illustrates:

Charles and Diane divorced in 2014. In 2013 Charles purchased 100 shares of XYZ stock. In 2019 Charles transferred the 100 shares of XYZ stock to Diane pursuant to their divorce agreement made in 2014. Since the transfer of stock occurred five years after Charles and Diane’s divorce, the transfer is tax-free under IRC Section 1041. 

Any transfer made more than six years after a marriage ends is presumed to be unrelated to the end of the marriage. These transfers do not qualify for tax-free treatment. But this assumption can be overcome by showing the transfer is the effect of the division of property owned by the former spouses as of the date the marriage ended.