On February 14, 2013, Jethro and Lee Ann’s divorce became final. Though the divorce was a foregone conclusion in your view, given Jethro’s unrepentant kleptomania and penchant for setting things on fire, still Uncle Bill and Aunt Ethel are torn up about their only son’s marital woes. You think your lucky stars that you are a tax attorney and stay away from family law like the plague. Nonetheless, you have developed relationships with the family law bar, and you referred Jethro to the one attorney that you absolutely loathe. Revenge, as they say, is a dish best served cold.
The Original 2013 Settlement Agreement
The marital settlement agreement stated that Jethro and Lee Anne would hold equal interests in the trailer where they had heretofore lived as tenants in common, and each would be responsible for the payment of an equal share of the mortgage, taxes, homeowner’s insurance, utilities, trailer park fees, and similar expenses. Improvements, repairs or changes to the structure or décor of the trailer would require the consent of both Jethro and Lee Anne before undertaking such repairs or changes, and the costs of these would be shared equally by Jethro and Lee Anne. If Jethro or Lee Anne desired to sell his or her interest, he or she would give written notice to the other owner to begin a 60-day period during which the owner receiving notice could purchase the interest of the owner giving notice.
The settlement agreement specified a purchase price of 50 percent of “gross equity” at the time of notice. The settlement agreement further defined “gross equity” as the current fair market value as established by a professional appraisal minus the then current payoff figure on the mortgage. If the owner receiving notice did not timely elect to exercise the option and consummate the purchase, then the trailer would be listed for sale to a third person. The personalty located in the trailer (mostly a collection of guns, collectible Pepsi bottles, and beanie babies) would be divided by mutual agreement at the time of a buyout or sale of trailer to a third party.
Jethro’s Pyromania and Ailurophobia Comes Full Circle
In June 2020, the trailer sustained heavy smoke and water damage during a fire at an adjoining home. You suspect that Jethro had something to do with the fire, and your suspicions are all but confirmed when they find a singed calico cat at the scene of the fire. (Jethro hated and feared cats something fierce.) As a result, the trailer required repairs well in excess of the repairs contemplated by Jethro and Lee Anne when they agreed to the settlement agreement.
In addition, the settlement agreement did not have a provision for resolving disagreements such as those that arose when Jethro and Lee Anne, communicating through their attorneys, attempted to obtain consent to repairs before repairs were undertaken. Consequently, in order for the necessary repairs to be undertaken and ultimate ownership of the trailer to be determined, Lee Anne, the party with the greater ability to handle unforeseen expenses, made disproportional contributions to pay the costs of repairs not covered by insurance.
The 2020 Modified Settlement Agreement
Following the completion of the repairs to the trailer, Jethro and Lee Anne negotiated a buyout of Jethro’s interest in trailer consistent with the provisions of settlement agreement. Because Jethro and Lee Anne wished to ensure that their buyout agreement did not violate the terms of the settlement agreement, Lee Anne petitioned the court to re-open the divorce case so that Jethro and Lee Anne could enter a new agreement with revised terms. On September 1, 2020, the court entered a modified settlement agreement to resolve the ultimate ownership of the trailer.
In the modified settlement agreement, Jethro and Lee Anne stipulated that each had obtained an independent appraisal of the fair market value of the trailer as a furnished unit, that the fair market value of Property is $15,000, and that the fair market value of Jethro’s undivided one-half interest in trailer is $7,500. In addition, Jethro and Lee Anne stipulated that Lee Anne had paid $5,000 and Jethro had paid $600 in costs related to maintenance, upkeep, remediation and repair of trailer (including payoff of the mortgage). Finally, Jethro and Lee Anne stipulated that Lee Anne would deliver to Jethro the “Net Purchase Price,” an amount equal to $1,900 ($7,500 – $5,000 – $600), and Jethro would deliver to Lee Anne a deed for trailer and a bill of sale for personalty located in trailer (save the one doe-eyed polar bear to which Jethro took a special shining). Jethro and Lee Anne carried out these transfers in accordance with modified settlement agreement.
The Legal Question
Uncle Bill comes to you regarding the proper tax treatment of the disposition of the trailer between Jethro and Lee Anne under IRC § 1041 and IRC § 2516. You can’t but admire his Google skills, as you explain the law of the case.
Treatment under IRC § 1041
IRC § 1041(a) provides that no gain or loss is recognized on a transfer of property from an individual to (1) a spouse, or (2) a former spouse if the transfer is incident to a divorce. The effect of IRC § 1041 is to defer the tax consequences (recognition of gain or loss) until the transferee disposes of the property. In turn, IRC § 1041(b) provides that in the case of any transfer to which IRC § 1041(a) applies, the property is treated as acquired by the transferee by gift for Federal income tax purposes, and the basis of the transferee in the property is adjusted basis of the transferor.
Treas. Reg. § 1.1041-1T(b), Q&A 7 provides that a transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument, as defined in IRC § 71(b)(2), and the transfer occurs not more than 6 years after the date on which the marriage ceases. A divorce or separation instrument includes a modification or amendment to such decree or instrument. Any transfer not pursuant to a divorce or separation instrument and any transfer occurring more than 6 years after the cessation of the marriage are presumed to be not related to the cessation of the marriage.
This presumption may be rebutted only by showing that the transfer was made to effectuate the division of property owned by the former spouses at the time of the cessation of the marriage. For example, the presumption may be rebutted by showing that (a) the transfer was not made within the one- and six- year periods described above because of the factors which hampered an earlier transfer of the property, such as legal or business impediments to transfer or disputes concerning the value of the property owned at the time of the cessation of the marriage, and (b) the transfer is effectuated promptly after the impediment to transfer is removed.
IRC § 71(b)(2) provides that the term ‘divorce or separation instrument’ means (A) a decree of divorce or separate maintenance or written instrument incident to such a decree, (B) a written separation agreement, or (C) a decree (not described in subsection (A)) requiring a spouse to make payments for the support or maintenance of the other spouse. The transfer of Jethro’s undivided one-half interest in the trailer to Lee Anne and the transfer of Net Purchase Price from Lee Anne to Jethro are pursuant to a divorce or separation instrument, as defined in IRC § 71(b)(2).
Treatment under IRC § 2516
IRC § 2501(a) imposes a tax for each calendar year on the transfer of property by gift during such calendar year by an individual. IRC § 2511(a) provides that the gift tax applies to a transfer by gift whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. IRC § 2512(b) provides that where property is transferred for less than an adequate and full consideration in money or money’s worth, the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift.
Finally, IRC § 2516 provides that where husband and wife enter into a written agreement relative to their marital and property rights and divorce occurs within the 3-year period beginning on the date 1 year before such agreement is entered into (whether or not such agreement is approved by the divorce decree), any transfers of property or interests in property made pursuant to such agreement (1) to either spouse in settlement of his or her marital or property rights, or (2) to provide a reasonable allowance for the support of issue of the marriage during minority, shall be deemed to be transfers made for a full and adequate consideration in money or money’s worth.
In this case, the divorce of Jethro and Lee Anne occurred less than 1 year before the original settlement agreement was entered by the court. Therefore, stipulations governing the trailer under the original settlement agreement are within the purview of IRC § 2516. Accordingly, transfers that Jethro and Lee Anne make pursuant to the original settlement agreement are deemed made for full and adequate consideration in money or money’s worth and, thus, are not subject to the gift tax.
The purchase price stipulated in the modified settlement agreement is consistent with the purchase stipulated in the original settlement agreement. Both settlement agreements call for the transfer of a one-half interest in the trailer in exchange for a purchase price equal to one-half of the fair market value of the trailer, calculated after Jethro and Lee Anne share equally the cost of paying off the mortgage and the costs related to maintenance, upkeep, remediation and repair of the trailer. The court entered modified settlement agreement to effectuate, under changed circumstances, transfers contemplated in the original settlement agreement to resolve ultimate ownership of the trailer.
While the transfers occurred more than 6 years after the date on which the marriage ceased, the modified settlement agreement was a modification and amendment to the original settlement agreement. The transfers were made to effectuate the division of property owned by the former spouses at the time of the cessation of their marriage. Accordingly, based on the facts submitted and the representations made, the payment by Jethro to Lee Anne of the Net Purchase Price and the transfer of Jethro’s undivided one-half interest in trailer from Jethro to Lee Anne constitutes transfers between former spouses that are ‘incident to divorce’ under IRC § 1041.
Furthermore, IRC § 2516 is applicable to transfers Jethro and Lee Anne made pursuant to the modified settlement agreement, and these transfers are deemed made for full and adequate consideration in money or money’s worth and, thus, are not subject to the gift tax. Accordingly, the payment by Lee Anne to Jethro of the Net Purchase Price and the corresponding transfer by Jethro to Lee Anne of Jethro’s 50% interest in the trailer constitute transfers for full and adequate consideration in money or money’s worth under IRC § 2516 that do not result in a taxable gift by either Jethro or Lee Anne.Add to favorites