Reach of Sec. 1041 Nonrecognition Provisions Expanded.

• Author: Bakale, Anthony

In Young, 240 F3d 369 (2001), aff'g 113 TC 152 (1999), the Fourth Circuit held that a taxpayer did not recognize gain on the transfer of appreciated land to his former spouse in settlement of his default on a promissory note. This result shifted the recognized gain to the former spouse on her sale of the land. Young is important, because it provides a precedent for gain nonrecognition for property transfers between former spouses that were not specified in the original property settlement.

Sec. 1041(a) and (b) provide that no gain or loss is recognized on property transfers between spouses or former spouses "incident to the divorce" and the transferee adopts the transferor's adjusted basis in the property. Sec. 1041(c) defines "incident to divorce" as transfers occurring within one year after the marriage ends or transfers "related to the cessation of the marriage." Sec. 1041 does not define "cessation of the marriage."

However, Temp. Regs. Sec. 1.1041-1T(b) provides a safe harbor for transfers made within six years of divorce under a Sec. 71 (b) (2) divorce or separation instrument, or a modification or amendment to such decree or instrument. Sec. 71(b)(2) defines a "divorce or separation instrument" as a "decree of divorce or separate maintenance or a written instrument incident to such a decree." If the property transfer is not made pursuant to a Sec. 71(b)(2) divorce or separation instrument, it is presumed to be unrelated to the cessation of the marriage, unless the taxpayer can show that the transfer was made to effect the division of the marital property. (The courts use "marital property" to mean property the spouses owned when the marriage ended.)

Louise and John Young were married in 1969 and divorced in 1988. Their 1989 settlement agreement provided for the equitable distribution of their property and all other claims arising out of their marriage. Under this agreement, John gave Louise a $1.5 million promissory note, payable in five annual installments, plus interest. The note was secured by land he received in the 1989 settlement. In 1990, John defaulted on the note and Louise sued. They settled and in December 1992, he transferred the land to Louise in discharge of $2,153,845 in debts to her, including the principal, accrued interest and her legal fees. His basis in the land was $130,794. John retained an option to repurchase the land for $2,265,000, which he transferred to Investment Partners, who exercised the option almost...