Interest income and deductions in marital property settlements.

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 taxed. The Gibbs court answered this argument by pointing out that unstated interest is not carved out in other payment situations involving gain exclusions (such as Secs. 104(a)(2) and 1033). Mrs. Gibbs also contended that because the courts have not allowed imputed interest to be deducted in marital settlements (see McCormick, TC Memo 1987-418), such interest should be excluded on the income side. The court's response to this argument was that Sec. 61 does not require consistency; it requires income to be reported unless it is specifically excluded.

Summary

It is well established that the imputed interest rules are not applicable to marital settlements. Further, recent cases indicate that the rationale in the imputed interest cases cannot be applied to stated interest situations. Thus, stated interest in a marital property settlement is includable in the transferor's income. The transferee's stated interest will be allocated to the assets transferred for the debt. Therefore, to the extent the debt is allocable to the residence or to investment property, deductions may be appropriate.

Several planning suggestions emerge from these cases. First, consider eliminating the interest component if the interest would not be deductible. For example, if property transferred is a passive activity and the transferee is not in a situation to use passive losses, interest could be eliminated by increasing the principal amount. This step will also have the advantage of decreasing income for the transferor, because of the inapplicability of the imputed interest rules. Second, interest that would be deductible could be lost if the IRS recharacterizes alimony as a property settlement. The unstated interest in such a situation could not be carved out and deducted after the fact. Third, consideration should be given to transferring assets that would result in an interest deduction under the tracing rules. In the Seymour case, the transfer of household furnishings, automobiles and an interest in a tax refund reduced the interest deduction. On the other hand, the transfer of a qualified residence and stock increased the transferee's mortgage interest and investment interest deductions. Fourth, an otherwise deductible item can be lost if the transferor has no legal interest in the asset. In Seymour, the court found that one of the real estate holdings transferred was not held by Mrs. Seymour prior to the divorce. Apparently, courts will not allow a portion of the debt to be allocated to property not owned in part by the transferor.