Section 1041 specifies that in general, transfers of property between spouses or former spouses made incident to a divorce, can be made without income tax consequence, unless property is transferred to a trust and liability transferred exceeds the basis of the property transferred. Property may be transferred to a third party by one spouse, on behalf of the other spouse, but recognition of gain is possible where the transfer is made to satisfy the obligation or liability of one spouse. Gain may be triggered if the property transferred is not used in the same purpose or manner as held before the transfer. Thus, an automobile used in an unincorporated business transferred to a nonowner spouse will cause depreciation recapture unless it is also used by the recipient spouse in a business.
The general rule under Section 1041 is that no gain or loss shall be recognized for property transferred to a spouse, or former spouse if incident to the divorce. The transfer is treated as a gift; the transferee has the transferor’s basis (Sec. 1040(b)). A transfer of property is incident to the divorce (Sec. 1040(c)) if such transfer occurs within one year after the date on which the marriage ceases, or is related to the cessation of the marriage.
Where property is transferred to a trust, gain will be recognized to the extent that (1) the sum of the liabilities assumed plus (2) the liabilities to which the property is subject exceed the total adjusted basis of the property transferred (Sec. 1040(e)). The amount of gain recognized will increase the basis to the transferee in such property.
Temp. Reg. Sec. 1.1041-1T (8-30-84) defines the scope of Section 1041 in that only transfers of property (real or personal, tangible or intangible) qualify. Transfers of deferred or unrecognized income will be taxed at the time of transfer to the transferor. However, a transfer of installment obligations will not trigger income (unless transferred to a trust for the benefit of the spouse) (Sec. 453B(g)).
A transfer of qualified stock options will render them nonqualified stock options and make them immediately taxable to the spouse who earned the options. Recent rulings also make them subject to FICA as well as income tax. But only the transferee spouse will recognize gain upon the eventual sale. The transferee spouse basis is the amount recognized as income by the transferring spouse at the time of transfer.
The transfers are presumed to be incident to the divorce in two circumstances
1) Transfer occurs not more than one year after the date on which the marriage ceases, or
2) Transfer is pursuant to a divorce or separation instrument and occurs not more than six years after the date on which the marriage ceases.
There are three situations where property transferred to a third party on behalf of a spouse will qualify under section 1041: 1) the transfer required by terms of divorce or separation instrument, 2) transfer is made by written request of spouse or former spouse, or 3) the transfer is made with written consent or ratification by spouse or former spouse. In this case, the deemed transfer from the transferring spouse to the transferee spouse qualifies for non-recognition of gain. However, the deemed transfer from the non-transferring spouse to the third party will not qualify for non-recognition under Section 1041.