Impact on divorce taxation issues of the Taxpayer Relief Act of 1997.

• Author: Frumkes, Melvyn B.

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 collectibles[6] 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. [sections] 1034 (the nonrecognition rollover rule) has been repealed and I.R.C. [sections] 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...