Interest income and deductions in marital property settlements.

• Author: Maples, Lawrence

Two 1997 cases illuminate the tax implications of stated interest in a property settlement incident to a divorce. At issue is the extent to Which Sec. 1041 affects the inclusion of interest income or the deduction of interest expense. These recent cases present an outstanding Opportunity to examine the interest implications of divorce settlements.

Sec. 1041 (a) provides that no gain or loss shall be recognized on a transfer of property from an individual to a spouse or former spouse if the transfer is incident to a divorce. Sec. 1041 (b) provides that the property shall be treated as acquired by the transferee by gift with a carryover basis from the transferor.

In John L. Seymour, 109 TC 14, the property settlement agreement required Mrs. Seymour to convey her interest in certain marital assets to Mr. Seymour for $300,000 and a $625,000 note payable over 10 years at 10% interest. The IRS argued that, because Sec 1041 (b) treats the transferee as having received a gift, the debt incurred by Mr. Seymour should not be treated as acquisition debt on the property, but instead should be allocated to his personal obligation. The Tax Court disagreed with the Service's position, noting its apparent inconsistency with several letter rulings. For example, a taxpayer who incurred interest to receive a principal residence in a marital settlement and who used the residence as security for the debt was entitled to a deduction for qualified residence interest (Letter Ruling 8928010).

The idea that the debt and the attendant interest should be viewed separately from the Sec. 1041 transfer had been considered by the Tax Court only a few months earlier. In Linda Gibbs, TC Memo 1997-196, a property settlement required Mrs. Gibbs to convey her interest in a convenience store in exchange for a note to be paid in 10 installments with stated interest. Mrs. Gibbs argued that the interest was excludable under Sec. 1041 (a), which provides for nonrecognition of gain from such settlements. She based her argument on Balding, 98 TC 368 (1992), in which a taxpayer settled her claim to her former husband's retirement benefits by agreeing to a settlement to be paid over three years. The court in Balding did not require interest to be included, because there was no stated interest. Nevertheless, Mrs. Gibbs argued that because the payments in Balding were spread over three years, a portion of each payment must have included interest, which the court did not require to be...