Most married couples purchasing a principal residence choose to title their residence in joint tenancy (joint tenants with right of survivorship or tenants by the entirety). As such, each spouse has a 50% interest in the property. Should they sell their residence and purchase a more expensive principal residence, Internal Revenue Code Section 1034 (hereafter referred to as Code Section 1034) permits each spouse to rollover his or her portion of the realized gain.
A divorcing couple may unfortunately face several financial and tax-related problems with respect to their jointly owned residence. Among these problems are the retitling of the jointly owned property and the rollover of gain provisions of Code Section 1034. In this article, we shall examine the consequences of divorce with respect to the retitling of property and to the rollover provisions.
Transfer of Title Related to Divorce
To understand the consequences of transferring title prior to divorce, we must examine pre- and post-July 18, 1984, transfers of property related to a divorce settlement. Before the passage of the Deficit Reduction Act of 1984, any transfer of property made before July 18, 1984, created a taxable event. In particular, if a spouse transferred property to the other spouse, the appreciated value above his or her adjusted basis was a recognized capital gain to the transferrer spouse.
Example: Howard and Sarah bought a home in 1970 at an adjusted cost of $30,000, titling it as 50/50 owners (each had a cost basis of $15,000). In 1982, they file for divorce with the value of their home at $100,000. As part of the divorce settlement, Howard agrees to transfer his portion of their residence to Sarah. This transfer creates a taxable event to Howard in the amount of a $35,000 recognized capital gain ($50,000 less $15,000). With the passage of the Deficit Reduction Act of 1984, any transfer of property (after July 18, 1984) between spouses or former spouses "related to" or "incident to" a divorce is considered a "gift" with no recognized gain (or loss) to either spouse. In that regard, the donee spouse will inherit the donor spouse's cost basis of the transferred asset. The only prerequisite is that the transfer must be related to a divorce settlement. The specifics of "related to divorce" or "incident to a divorce" will be explained in more detail below.
The significance in the change of tax treatment behind the pre- and post-July 18, 1984, asset transfers is important. The reasoning behind the change was that the spouse who remained in the house would be eligible to utilize the Code Section 1034 rollover (and ultimately the Code Section 121 $125,000 capital gain exclusion, if eligible) should the residence be sold in the future. On the other hand, the transferrer spouse could purchase a new residence without restriction (related to the provisions of Code Section 1034). In particular, there would be neither a minimum purchase price (exceeding his or her cost basis in the old residence or transfer price to the other spouse) requirement nor a time restriction (two years before or after the transfer to the other spouse) in acquiring a new principal residence. Most important, in accordance...