Impact on Divorce Taxation Issues of the Taxpayer Relief Act of 1997
Many provisions of the Taxpayer Relief Act of 1997, passed on August 5, 1997, have a major impact on various divorce taxation issues. Consideration by Florida courts in the valuation of marital assets of the contingent tax liability will be impacted substantially by the new capital gain rates and holding period, as well as the completely renovated rules on exclusion of most gains on the sale of a principal residence. The new rules also will give needed relief to the spouse (or ex-spouse) who has vacated the principal residence but has not yet sold his or her interest. The Act provides for a child tax credit of $500 ($400 in 1998) for those who are able to take the dependency exemption. The Act also waives the 10 percent penalty for early withdrawal from IRAs for higher education expense and for first-time homebuyers. Finally, the 15 percent excise tax for excess distributions from qualified retirement plans and IRAs is completely abrogated.
Contingent Tax Liability in Valuation of Marital Assets
If property is transferred between spouses or former spouses incident to a divorce, the tax basis of the transferred property is the adjusted basis in the hands of the transferor immediately prior to the transfer.1 Thus, if there is a gain in value over the basis at the time of transfer, no income tax is imposed at the time of transfer. However, the transferee will have a contingent income tax liability.
If the value of marital assets is to be reduced by the tax that would be imposed upon the eventual sale, capital gain income tax rates and holding periods must be considered. While Florida courts generally adhere to the majority position that where there is no contemplated or court-required sale of the property, such tax consequences are speculative and should not be considered,2 there are many cases in Florida that for one reason or another hold that the contingent tax liability is appropriate for the court to consider.3 It is, therefore, incumbent upon practitioners to tax effect all marital assets subject to distribution. Recent Florida appellate decisions have held that any party seeking consideration of tax consequences should assist the trial court by demonstrating the tax consequences of all tax burdened marital asset no matter who is to receive that asset, and not just a select few.4
Accordingly, the major changes that have been made to capital gain rates and holding periods by the Taxpayer Relief Act of 1997 are of great significance.
Under the Act, the capital gain rate drops from a maximum of 28 percent to 20 percent for a holding period of 18 months. For a holding period of more than one year but not more than 18 months the capital gain rate remains at 28 percent.
To the extent of depreciation claimed on real estate, a maximum rate of 25 percent will apply.
Beginning in the year 2001, the maximum rate for property acquired that year or later, held for more than five years, will be 18 percent. For property acquired before the year 2001, an 18 percent rate can be utilized by paying the capital gains tax on the appreciation as of that date. The 18 percent rate will then apply to any future appreciation of property held for more than five years.5
A 28 percent maximum rate continues on the sale of collectibles6 held for more than a year.
If the taxpayer is in the 15 percent marginal tax bracket, the top long-term capital gain rate will be 10 percent and eight percent for property held for more than five years after the year 2000.
Exclusion of Gain on
Sale of Principal Residence
Under the Act, there are substantial changes in the tax treatment of the sale or exchange of one’s principal residence. I.R.C. §1034 (the nonrecognition rollover rule) has been repealed and I.R.C. §21 (the $125,000 one-time exclusion for those 55 years of age and older) has been completely amended.
Now each taxpayer, regardless of age, can exclude up to $250,000 in gain on the sale or exchange of his or her interest in the principal residence where the ownership and use test is met,7 unless an election is made otherwise.8
The principal residence that is sold or exchanged must have been owned and used by the taxpayer for two or more years during the five-year period ending on the date of sale or exchange.9
Under the Act, the ownership and use test is expressed in terms of “owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.”10 Thus, continuous and uninterrupted use and ownership is not necessary, only for a cumulative two-year period.
Under former I.R.C. §121, the Code required ownership and use for a period “aggregating three or more years.” The Internal Revenue Service’s Regulations interpreted that to mean that the three-year requirement can be satisfied “by establishing ownership and use for 36 full months or for 1,095 days.”11 Accordingly, one should be able to presume, at least until the new Regulations are promulgated, that the two-year use and ownership requirement under the Act can be at any time during the five-year period so long as it aggregates two years (an aggregate of 730 days). The Regulation goes on to provide that “short temporary absences such as for a vacation or other seasonal absence (although accompanied with rental of the residence) are counted as periods of use.” Again, it is probable that the same language will be applicable to the use and ownership requirements as provided under the Act.
For the purpose of the current two-year use and ownership rule, a taxpayer who deferred tax on a gain under the provisions of the then existing rollover provision of I.R.C. §1034 can tack on the old home’s ownership and use period to that of the new home.
The Internal Revenue Service Regulations describe a principal residence as including “a houseboat, a house trailer or stock held by a tenant-stockholder in a cooperative housing corporation.”12
If a joint return is filed, the exclusion is up to $500,000 if 1) either spouse satisfies the ownership test; 2) both spouses satisfy the use test; and 3) neither spouse is ineligible for the exclusion because of a sale or exchange within the two-year period.13 If one spouse is ineligible to use the exclusion because it was used within the two-year period when single, it will not preclude the other spouse from claiming the exclusion; however, the spouse entitled will be limited to a $250,000 exclusion.
In the case of joint filers not sharing a principal residence, an exclusion of $250,000 is available on a qualifying sale or exchange of the principal residence of one of the spouses. Once both spouses satisfy the eligibility rules and two years have passed since the last exclusion was allowed to either of them, the taxpayers may exclude $500,000 of gain on their joint return.
The exclusion can be claimed every two years for the sale of a principal residence but only once during each two-year period.14 A pre-May 1997 sale is not taken into account as to the once-every-two-year rule.15
The previous taking of the $125,000 exclusion pursuant to the pre-Act version of I.R.C. §12116 will not preclude the utilization of the now-available $250,000 exclusion ($500,000 for married, filing jointly), if all other requirements are met.
A spouse or former spouse who has a principal residence distributed to him or her (an I.R.C. §1041 transaction) can tack on the transferor’s ownership to his or her own ownership.17 Accordingly, although the new title holder did not own the house for the entire two of the past five years, the ownership by the departing spouse will suffice.
The Act will now give relief to the “out” spouse or former spouse notwithstanding that the principal residence is not sold until after three years from the “out” spouse’s departure. The Act provides that an individual is treated as using the principal residence during any period that the remaining spouse is granted use of the principal residence under a divorce or separation instrument.18
Child Tax Credit
In addition to the dependency exemption,19 the Act has added another benefit for taxpayers with children who can claim the dependency exemption. It is the child tax credit,20 which is an offset against tax liability. Any excess over actual tax liability is lost.
The child tax credit cannot be split from the parent who can take the dependency exemption. Pursuant to the Internal Revenue Code,21 It is the custodial parent who can claim the dependency exemption and thus, in addition, the child tax credit, unless the custodial parent gives to the noncustodial parent a waiver allowing that parent to take the dependency exemption. In Florida, most circuit courts can and do allocate the dependency exemption to the noncustodial parent by requiring the custodial parent to execute the required waiver if it will effect a tax savings resulting in more dollars available for child support.22 Notwithstanding the holding in the other districts and the provisions of F.S. §61.30(11)(i),23 circuit courts in the Second District Court of Appeal are still prohibited from allocating the dependency exemption.24 Now with the added benefit of the child tax credit, which is coupled with the dependency exemption, the sole prohibition against allocating by the courts in the Second District appears to be even more harsh.
The child tax credit will be for each qualifying child25 who is under the age of 17 at the end of the tax year. The amount of credit for each child is $400 for 1998 and $500 for each year thereafter. The term “qualifying child” does not include a child “who is not a citizen or national of the United States unless such [child] is a resident of the United States.”26
If a taxpayer has three or more qualifying children, there are certain other benefits concerning the credit that may be taken.
The tax saving of the child tax credit commences to phase out at different levels than the commencement of phase-out for the dependency exemption. The phase-out for the child tax credit begins at a modified adjusted gross income27 for joint filers at $110,000, single filers and head of household at $75,000, and $55,000 for married filing separately.
The phase-out for the total child tax credit ( i.e., the credit amount times the number of qualifying children) is $50 for each $1,000 (or part thereof) of modified adjusted gross income above the thresholds. Neither the amount of credit nor the phase-out thresholds will be indexed for inflation for the child tax credit.28
J. Dennis Casty, CPA, CFP, of FinPlan Co., Park Ridge, Illinois, notes that “accurate computation of the child tax credit is complicated, especially for low income individuals.”
Because of this additional benefit to the party who has the dependency exemption, the right to have the dependency exemption likely will be contested more.
Waiver of Penalty for
Early IRA Withdrawal
A limited source of funding for specialized needs for taxpayers younger than age 59 1/2, and thus for any such divorcing parties, can be found in an IRA.
Commencing in 1998,30 there will be no 10 percent penalty for withdrawal from IRAs prior to age 59 1/2 for qualified higher education expenses (including those related to graduate-level courses at a post-secondary educational institution31 ) for the taxpayer, the taxpayer’s spouse, child, or grandchild of the taxpayer or the taxpayer’s spouse. Of course, such withdrawals will be subject to regular federal income tax. Qualified expenses include tuition fees, books, supplies, room and board, and equipment required for enrollment or attendance at an eligible education institution. It should be noted that there is no penalty-free provision for the pre-age 59 1/2 withdrawal from a qualified plan. Thus, it may benefit the taxpayer to roll over part of that which is in a plan, if possible, into an IRA.
Further, after 1997, there can be a 10 percent penalty-free withdrawal from an IRA for a first-time homebuyer32 of a principal residence for the taxpayer, the taxpayer’s spouse, or a child, grandchild, or ancestor of either. A lifetime $10,000 limitation is imposed “for qualified acquisition costs.”33 the distribution from the IRA must be used for such purpose within 120 days of withdrawal.
From Retirement Funds
Under prior law a 15 percent excise tax was imposed on excess distributions from qualified retirement plans, tax shelter annuities, and IRAs. The tax did not apply for the years 1997 through 1999. An additional 15 percent estate tax was imposed on an individual’s excess retirement accumulations.
No longer will a spouse or ex-spouse who has substantial retirement funds be able to argue against substantial taking down of those funds because of an excise tax. The Act repeals both the 15 percent excise tax on excess distributions from qualified plans, tax shelter annuities, and IRAs, and the 15 percent excise on excess retirement accumulations. This can provide a needed source of funding to meet the requirements of the marital settlement agreement or the final judgment for dissolution of marriage.
1 I.R.C. §1041.
2 Levan v. Levan , 545 So. 2d 892 (Fla. 3d D.C.A. 1989); England v. England , 626 So. 2d 330 (Fla. 1st D.C.A. 1993).
3 Privett v. Privett , 535 So. 2d 663 (Fla. 4th D.C.A. 1988) (taxes suffered from premature withdrawal from savings plan); Werner v. Werner , 587 So. 2d 473 (Fla. 3d D.C.A. 1991) (tax liabilities and accounts under installment sales contracts); Nicewonder v. Nicewonder , 602 So. 2d 1354 (Fla. 1st D.C.A. 1992) (contingent income tax liabilities generated during the marriage); Miller v. Miller , 625 So. 2d 1320 (Fla. 5th D.C.A. 1993) (sale of assets likely considering the ages of the parties); Yunus v. Yunus , 658 So. 2d 1043 (Fla. 1st D.C.A. 1995) (substantially unequal IRA distribution); Miller v. Miller , 662 So. 2d 391 (Fla. 5th D.C.A. 1995) (property awarded wife tax effected as well as property awarded husband).
4 Vacarro v. Vacarro , 677 So. 2d 918 (Fla. 5th D.C.A. 1996); Hollinger v. Hollinger , 684 So. 2d 286 (Fla. 3d D.C.A. 1996).
5 That is an election “to treat the asset as having been sold on such date for an amount equal to its fair market value and as having been reacquired for an amount equal to such value. If the election is made, any gain is recognized (and any loss disallowed).” Conference Committee Report, p. 65.
6 Such as artworks, jewels, antiques, stamp and coin collections.
7 I.R.C. §121(b)(1).
8 I.R.C. §121(f).
9 I.R.C. §121(a).
11 Treas. Reg. §1.121-1(c).
12 Treas. Reg. §1.1034-1(c)(3). Although this regulation applied to I.R.C. §1034, now repealed, it is presumed the IRS will adopt the same definition to apply under the amended I.R.C. §121.
13 I.R.C. §121(b)(2).
14 I.R.C. §121(b)(3)(A).
15 I.R.C. §121(b)(3)(B).
16 Melvyn B. Frumkes, Divorce Taxation Handbook §2.2.3, at 34 (2d Ed.).
17 I.R.C. §121(d)(3)(A).
18 I.R.C. §121(d)(3)(B).
19 See Frumkes, Divorce Taxation Handbook §5, at 101–123 (2d Ed.); and I.R.C. §§151 and 152.
20 I.R.C. §24.
21 I.R.C. §152(e)
22 Griffin v. Griffin , 665 So. 2d 352 (Fla. 1st D.C.A. 1996); Ford v. Ford , 592 So. 2d 698 (Fla. 3d D.C.A. 1991); Fenner v. Fenner , 599 So. 2d 1343 (Fla. 4th D.C.A. 1992); Vick v. Vick , 675 So. 2d 714 (Fla. 5th D.C.A. 1996).
23 Fla. Stat. §61.30(11)(i). “The court may order the primary residential parent to execute a waiver of the Internal Revenue Service dependency exemption if the non-custodial parent is current in support payments.”
24 Gary v. Gary , 658 So. 2d 607 (Fla. 2d D.C.A. 1995).
25 A qualifying child is defined as “an individual for whom the taxpayer can claim a dependency exemption and who is a son or daughter of the taxpayer (or a descendent of either), a stepson or stepdaughter of the taxpayer or an eligible foster child of the taxpayer.” I.R.C. §32(c)(B).
26 I.R.C. §§24(c)(2) and 152(b)(3).
27 Modified adjusted gross income is the AGI increased by foreign (I.R.C. §911), possessions (I.R.C. §931), and Puerto Rico (I.R.C. §933) income exclusions.
28 The phase-out thresholds for the dependency exemption is adjusted each year for inflation. I.R.C. §151(d)(4).
29 The phase-out for the dependency exemption is two percent for every $2,500 ($1,250 for married, filing separately) of AGI above the phase-out threshold.
30 Pursuant to I.R.C. §203.
31 Throughout the Conference Committee Report it describes such institutions generally as “accredited post-secondary educational institutions offering credit toward a bachelor’s degree, an associate degree, or another recognized post-secondary credential. Certain proprietary institutions and post-secondary vocational institutions also are eligible educational institutions.”
32 The Act defines “first-time home-buyer” as an individual (and if married, such individual’s spouse) who “has no present ownership interest in a principal residence during the 2-year period ending on the date of acquisition of the principal residence to which [the section of the Act] applies.” §303(b) of the Act. I.R.C. §72(t)(8)(D)(i), as amended.
33 The Act defines “qualified acquisition costs” as “the cost of acquiring, constructing or reconstructing a residence. Such term includes any unusual or reasonable settlement, financing, or other closing costs.” §303(b) of the Act. I.R.C. §72(t)(8)(C), as amended.
Melvyn B. Frumkes maintains offices for the practice of law in Miami and Boca Raton and restricts his practice to marital and family law. He is a graduate, with honors, from the University of Florida College of Law. He is the author of “Divorce Taxation Handbook: A Practical Guide for Lawyers, Judges & Accountants,” 2d Ed.. Mr. Frumkes is a fellow of the American Academy of Matrimonial Lawyers and the American Law Institute, a diplomate of the American College of Family Trial Attorneys, and a fellow of the International Academy of Matrimonial Lawyers. He is board certified in marital and family law.
This column is submitted on behalf of the Family Law Section, Deborah B. Marks, chair, and Susan G. Chopin and John S. Morse, editors.