As you probably know, California is a community property state. This means that if and when you and your spouse divorce, each of you is entitled to 50 percent of your marital assets. How you go about dividing up those assets, however, and the manner in which you do it, could have negative tax consequences for one or both of you.
The Tax Adviser explains that, in general, the Internal Revenue Code does not treat divorce as a taxable event per se. Both Section 1041 pertaining to income taxes and Section 2516 pertaining to gift taxes make this quite clear. Nevertheless, you need to be very careful in crafting your property settlement agreement so that transfers from one of you to the other and vice versa do not themselves create taxable events.
You and your spouse should work closely with your respective attorneys, accountants and/or tax advisors to ensure that your property settlement provisions do not run afoul of Section 1041 of the IRC. This section does not recognize your divorce as a triggering event for income or capital gains or losses purposes as they pertain to what you must include on your income tax return. Be aware, however, that if your property settlement agreement calls for the transfer of property from one ex-spouse to the other after your divorce, this nonrecognition applies only if the transfers occur within one year after your marriage ends or within six years after it ends and you make the transfers in accordance with your property settlement agreement or any amendment or modification thereto.
Your property settlement agreement likewise must not run afoul of Section 2516 of the IRC. This section pertains to the gift tax that one spouse might normally need to pay when (s)he transfers property to the other spouse. However, Section 2516 grants nonrecognition of gift tax status only to those “gifts” either of you makes to the other pursuant to your written property settlement agreement and which resolve your mutual marital and property rights or which you and/or your spouse make in support of your children.
Unfortunately, property settlement agreements can and often do become highly complex documents. The more property and assets you and your spouse accumulated during your marriage, the more care you should take to ensure that your property settlement agreement does not inadvertently contain any provisions or language that could cause one or both of you any unexpected negative tax consequences.
This is educational information only and not intended to provide legal advice.