Interest expense incurred in property settlement is deductible.

IRC section 1041 provides that a taxpayer recognize no gain or loss on property settlement transfers that are incident to a divorce. Instead, these transfers are treated as gifts with the recipient taking a carryover basis. Because of liquidity and cash flow problems, property settlements may involve multiyear transfers, promissory notes and loans. If a taxpayer incurs interest expense related to such transfers, can he or she deduct that interest?

As part of a divorce settlement, John Seymour received stock, real estate and the family residence. In return, he transferred to his former spouse cash plus a $625,000 note payable in semiannual installments over 10 years, with interest. On his tax return, Seymour deducted the interest as part investment interest and part qualified residence interest. Relying on the interest allocation rules of temporary regulations section 1.163-8T, he argued he was entitled to allocate the debt related to the assets he had received and to deduct the interest expense accordingly.

The IRS denied the interest expense deduction, arguing that all interest was nondeductible personal interest since section 1041 treats the settlement transaction as a gift.

Result: For the taxpayer. The Tax Court pointed out that in Gibbs (TC memo 1997-196) it previously had held that interest received as part of a property settlement was includable in income. The interest was not excludable under section 1041 because that section applies only to the gain or loss on property transfers, not to separately stated interest income. This conclusion is consistent with IRS notice 88-74, and private letter rulings 8928010 and 9031022, which say that section 1041 does not prohibit a taxpayer from taking an interest expense deduction if the debt was incurred to acquire a residence. Therefore, the interest expense Seymour incurred on the note he transferred to his spouse may result in deductible interest depending on the assets received.

To determine the deductible portion, a taxpayer must first allocate the debt to the residence, if appropriate. This would be the case if the taxpayer incurred the debt to acquire or improve the residence and the note is secured by the residence itself. The fact that it may be subordinated to an existing mortgage is immaterial. After allocating the debt to the residence, any remaining debt is allocated to other property the taxpayer receives. Then, each property should be examined to determine if it qualifies as investment property or as a passive activity. To the extent it does, the interest is deductible. The remainder is nondeductible personal interest.

Taxpayers attempting to deduct interest must be able to point to a note or agreement that specifically requires an interest payment. The fact that the property settlement occurs over several years will not permit the taxpayer to impute interest expense, except in very unusual circumstances.

* John L. Seymour v. Commissioner, 109 TC no. 14, 1997.

Prepared by Edward Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.