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How does divorce affect your taxes? Part 2: property transfers

Let’s continue our discussion of ways in which divorce can affect your taxes. In part one of this two-part post, we explained that even something as seemingly simple as filing status is not always as straightforward as it seems.

In this part of the post, we will consider the question of property transfers between spouses.

Before discussing property transfers, however, we should take note of the availability in appropriate cases of something called innocent spouse relief. This is a form of relief from tax liability that may be allowed for a spouse or former spouse on a joint return.

Sometimes the spouse or former spouse who handled the couple’s finances understated income or overstated deductions, resulting in significant liability for back taxes. When this happens, it may be unfair to hold the spouse or former spouse who did not handle the money jointly liable for errors he or she had no reason to know about. We discussed this issue in our September 12 post last year.

Having taken note of innocent spouse relief, let us turn then to the tax treatment of transfers between spouses as part of a divorce settlement. IRS Publication 504 explains that generally spouses do not have to recognize gain or loss in connection with these transfers. Federal gift tax also usually does not apply when property changes hands between spouses incident to divorce.

For the nonrecognition rule to apply, however, the property transfer must meet certain criteria on its connection to the end of your marriage. The transfer has to be part of the settlement document for your divorce or legal separation, either originally or as modified. And it must be made within six years after the divorce or separation takes effect.

A common example of such a transfer is interest in a home that a couple owned jointly before their divorce. One former spouse often transfers his or her interest to the other as part of their property settlement.

Source: IRS.gov, “Publication 504

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