Many of us have worked on cases where the ultimate property settlement was hampered due to lack of liquidity. This often occurs in families where the most significant asset is either a closely held business or real estate.
Often one of the parties requests that the ultimate disposition of these non-liquid assets be finalized some time in the future when the closely held business or real estate interest is sold. He or she further posits that the real value of these assets will only be known with certainty at the time of sale.
Although this is a strong argument, this is often described as a “RFD” (recipe for disaster). There is a significant tax reason not to delay the property settlement until the ultimate sale.
The Internal Revenue Code states that “no gain or loss is recognized to the transferor on a transfer of property between spouses or between former spouses incident to a divorce, nor is the value of the property included in the gross income of the transferee”.
A property transfer is deemed to be incident to a divorce if
* The transfer occurs within one year after the date the marriage ends, OR
* The transfer is related to the ending of the marriage
A property transfer is related to the ending of the marriage if
* The transfer is made under the original or modified divorce or separation instrument, AND
* The transfer occurs within six years after the date the marriage ends.
This tax free transfer of property between divorcing parties is a tremendous tax benefit. If the ultimate transfer does not occur under these rules, the tax consequences could be devastating. For example, let’s assume 50% of the proceeds from the sale of a closely held business are transferred to a former spouse outside the requisite time period. Let’s further assume the company originally cost $100,000 and is valued at $400,000 at the time of the transfer. Tax will be owed on 50% of the $300,000 gain ($400,000 less $100,000) by the transferor. Even if the tax is incurred at capital gains tax rates, the tax is unnecessary.