When a spouse purchases property in a 1031 exchange, they have a lower basis (than a normal cost basis) in the property to the extent that they have deferred gains and rolled over into the new replacement property. This may be called a substituted basis or reduced basis due to the taxes that were deferred in the exchange.
Depreciation Deductions
If, in addition to starting with a lowered basis, the spouse then took depreciation deductions for the wear, tear, and exhaustion of the property, then the remaining basis would have been further reduced each year incrementally as these depreciation deductions were taken.
Section 1041
Years later, if the spouse gets divorced and transfers the replacement property to their ex-wife/husband (former spouse) as part of a divorce property settlement, then the former spouse will take the property with a straight carry-over basis under IRC Section 1041 (transfers of property between spouses or incident to divorce), so they get the property with a super low basis, being whatever remaining basis the transferor had left in the property. Section 1041 makes transfers between spouses tax-neutral, in that the receiving spouse just takes the transferred property subject to the other spouses basis.
Section 121 Exclusion
If the former spouse moves into the property and makes it their principle residence, they may be able to take a partial exclusion under IRC Section 121 once they have owned and lived in the property for two years; however, the amount of the exclusion allowed is a fraction based upon the ratio of the time the property was used as a rental and the amount of time it was used as a principle residence. Further, IRC Section 121 is inapplicable to deprecation recapture. So, the former spouse will only get to use a fraction of the principle residence as it relates to the appreciation (or natural increase in value over time), but will not be able to exclude any gains attributable to the past depreciation that was taken by either or both spouses.
Unrecaptured Depreciation
Unrecaptured depreciation may be taxed at a maximum rate of 25% on most US real property. While normal long term capital gains are taxed at a maximum rate of only 20%.
In summary, if you receive property in a divorce property settlement that was originally purchased to complete a 1031 like-kind exchange…you may be receiving the property with an unexpectedly low basis and additional potential tax complications. These tax complication may be compounded by the limitations imposed in Section 121 for the principle residence exclusion that carve-out from the exclusion the deprecation recapture
PROTIP: Let the entrepreneurial spouse keep the old low basis property, and have the other spouse receive cash! Cash is king.
Start Your Exchange: If you have questions about tax implications of property in a divorce, feel free to call me at 612-643-1031.
Defer the tax. Maximize your gain.
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