Page 71 - Family Law Services

IRC Section 121(d)(3)(B) also permits carryover of the spouse’s and former spouse’s ownership periods.
If a residence is transferred incident to divorce, the time the individual’s former spouse owned the resi-
dence carries over to the receiving spouse. For example, assume W owns the family home and transfers
it to H pursuant to a divorce judgment. The transfer is tax-free to H as a transfer incident to divorce un-
der IRC Section 1041, and W’s holding period carries over to H. Ordinarily, H would have to wait two
years to meet the ownership requirements to qualify for the exclusion.

Allocation of Income, Deductions, Credits, and Payments in the Year of Divorce

If the parties reside in a common law or equitable distribution state, the income, deductions, payments,
or credits are treated as belonging to the party that earned the income or owned the property from which
it was generated. There are, however, a few exceptions to these rules.

Community property law. In the year of separation or pendency of the divorce proceedings (or in the
predivorce years in which the parties file separately), the IRS generally requires the application of com-
munity property rules with respect to income, deductions, payments, and credits earned by both parties
during the portion of the year prior to the termination of the community, as determined under local law.
These items are reportable one-half by each spouse on his or her separate returns (or joint return with a
new spouse) filed for the year.

The allocation is determined by the application of appropriate state law. That law is typically the law of
the state with jurisdiction during the divorce. Separate property income, deductions, payments, and cred-
its are reported on the return of the individual whose property created the item. Exceptions include So-
cial Security benefits and taxes, as well as individual retirement account (IRA) deductions, which are
considered by federal law to be the owner’s separate property without regard to local law.

Pass-through entities. Generally, allocations are made on the basis of state law (equitable distribution
and community property laws). However, when dealing with a pass-through entity, such as an S corpo-
ration, a limited liability company, or a partnership, the IRS allows two different methods to allocate tax
attributes (income, deductions, and so on) in the year during which the taxpayer’s ownership of the enti-
ty terminates. Depending on the nature of the ownership, this can affect the allocation and amount of in-
come taxes payable in the year of the divorce:

• Under the first method, the tax attributes from the pass-through entity are allocated based on a
ratio of ownership days. This is typically based on the number of ownership days for the specific
individual compared to the ownership days of all the individuals owning the entity for the entire
year.

• The second method determines the actual income or loss and other tax attributes through the date
the individual’s ownership terminates. These tax attributes are then allocated according to the
computation of the preownership termination versus the postownership termination amounts.
Large differences in tax liability can accrue to the nonparticipating spouse under this method,
particularly if one spouse controls the entity after the divorce, or there are seasonal fluctuations
in the business, or both.

It is important for the CPA to determine which method is in his or her client’s best interest and urge the
specification of that method in the divorce decree.

State and Local Taxes. Under TCJA, itemized deductions for certain income, property, and sales tax are
limited to $10,000 ($5,000 for married taxpayer filing a separate return) (Act Sec 11042)

© 2020 Association of International Certified Professional Accountants 69