Deductibility of interest paid to former spouse.

The IRS considers the transfer of property between spouses in a divorce proceeding to be gifts and not taxable transactions. When one spouse receives more property than the other, a settlement may involve a debt from one spouse to the other to equalize the distribution. Is the interest incurred on such a debt deductible?

In John L. Seymour v. Commissioner, 109 TC no. 14 (1997), the Tax Court held that IRC section 1041 does not apply to interest expense on debt incurred in connection with a divorce. (See JofA Apr. 98, pages 72-73). Instead, the normal tracing rules are used to characterize the interest according to the purpose of the loan.

In Ronald R. Armacost and Cathy L. Armacost v. Commissioner, TC Memo 1998-150 (1998), a taxpayer received more property than his wife in their separation agreement so he gave her a promissory note with a stated interest rate of 10%. The couple had always resided in community property states and had accumulated assets including commercial properties, stocks, bonds, a residence and vacation homes. The wife was also granted a security interest in the properties transferred to her husband under the agreement. Mr. Armacost made payments under the note and deducted the interest paid on his 1992 return.

Using the same argument as in Seymour, the IRS disallowed the interest deduction because the underlying reason for the debt, on which the interest was being paid, was a personal one--the divorce. Personal interest is not deductible unless it meets one of the exceptions of section 163 (h) (2), including interest allocable to a trade or business investment or to a qualified residence.

The Tax Court held that the investment interest exception applied in this case and that, to the extent the note was made to acquire Mr. Armacost's community ownership in their investment property, the interest was deductible under section 163. The court applied the tracing rules and looked at the nature of the underlying assets acquired as a result of the divorce.

Observation: If a property transfer occurs in a divorce settlement, the debt instrument should include a stated rate of interest, and the nature of the underlying property should be characterized in the settlement agreement. This identification will allow for the allocation of any interest between deductible and nondeductible amounts.

--Tina Steward Quinn, CPA, PhD, assistant professor of accountancy, Arkansas State University and Tonya K. Flesher, CPA, PhD, Arthur Andersen Lecturer and professor of accountancy4 University of Mississippi.