As if divorce were not a stressful enough time, the complexities of the US tax rules when a non-US spouse is involved just make it all the more unbearable. Keep in mind, too, that foreign divorces can add further legal complexity to the mix and professional help should always be sought. This is so because when foreign laws and processes come into play, the rules can change dramatically.
Here are the US tax basics to keep in mind with respect to property transfers at divorce. Payments of alimony were the subject of my earlier tax blog posting. (This earlier posting contains the latest information about alimony rules under the tax legislation overhaul wrought last year by the Tax Cuts and Jobs Act, “TCJA”).
You May Have Both Income Tax and Gift Tax Issues
Under the general US tax rules, asset transfers between spouses incident to a divorce are tax-free under Code Section 1041. There is no realization of a gain or loss by the transferor-spouse upon such a transfer of property. Instead, the transfer is treated as a “gift”. If the spouses are both US citizens, the case is straightforward and simple – no US Income tax or Gift tax consequences will result. Not so simple if one spouse is a non-US citizen and even more complex if the non-citizen spouse is also a “nonresident” alien (NRA).
A transfer is treated as incident to a divorce if it takes place within a year of the divorce or is “related to the cessation of the marriage”. Generally, a transfer is related to the cessation of the marriage if it is pursuant to a divorce or separation agreement and occurs not more than 6 years after the date on which the marriage ceases.
Very significantly, in order for the income tax-free treatment of Code Section 1041 to apply, the recipient of the property cannot be a “nonresident alien” (NRA). For example, if you transfer appreciated stock to your NRA spouse as part of the divorce settlement, you will have to pay tax on the inherent gain in the stock, generally just as if you sold it.
Who is a Nonresident Alien?
Remember, the different income tax rule applies only if the spouse receiving the property is a “nonresident alien”. This means he or she is not a US citizen and also not a US “resident” for income tax purposes.
Whether an individual is a US “resident” is not as easy to ascertain. For US income tax purposes, a resident is an individual who holds a US “green card” or who meets the so-called “substantial presence” test. This generally means that the person spends a sufficient number of days in the United States every year.
An individual will qualify under the substantial presence test if either he is physically present: (1) in the US for 183 days or more during the current calendar year or, (2) for at least 31 days during the current calendar year and the sum of the days present in the US during the current calendar year, plus one-third of the days he was present in the US during the immediately preceding calendar year, plus one-sixth of the days he was present in the second preceding calendar year, is 183 days or more. Various exceptions apply and a full discussion should take place with tax counsel in order to make sure of the recipient spouse’s tax status. For more information on the rules, see IRS Publication 519, U.S. Tax Guide for Aliens.
In some cases when spouses are terminating the marriage, you may have gift tax consequences. This can occur, for example, if the transfer takes place while the couple is still legally married and is not made pursuant to a separation agreement.
Let’s understand some basics. The US gift tax is imposed on the giver of the gift, not on the recipient. Gifts made to US-citizen spouses, may be exempt from gift tax regardless of the amount. When the recipient spouse is a US citizen, the gift tax will not apply because gifts made between spouses are entitled to a so-called “unlimited marital deduction” which will shield the giver of the gift from any US gift tax. The key is that the recipient must be a US citizen.
When the recipient spouse is not a US citizen, the unlimited federal gift tax marital deduction does not apply, even if the recipient is a US “resident” for income tax purposes. Instead, gifts to noncitizen spouses have a very large annual exclusion which is indexed annually for inflation. For calendar year 2018, gifts to non-US citizen spouses are permitted an annual amount of $152,000; for 2019 the amount is $155,000.
Even if the gift to an NRA spouse exceeds this annual limit, the giver of the gift may still be shielded from immediate gift tax consequences. Aside from spousal gifting, US citizens and “residents” are permitted a very generous lifetime exclusion amount. This exclusion amount was substantially increased by TCJA. The exclusion amount permits a US individual to make lifetime gifts without payment of US gift tax if the gifts do not exceed the exclusion amount threshold. Prior to TCJA, the exclusion amount was $5 million; it has increased to $10 million for tax years 2018 through 2025. The exclusion amount is indexed annually for inflation and for 2018 is worth a whopping $11.18 million; for 2019 it is worth $11.4 million. Foreign individuals who are not US “residents” for gift tax purposes, however, are not entitled to this lifetime exclusion. So, depending on the facts involved, they can be subject to US gift tax
The combination of the US income tax and US gift tax rules means that every property settlement incident to a divorce when the recipient is not a US citizen must be scrutinized for both potential income tax and gift tax liability which can be imposed on the transferor-spouse. Just because your spouse may hold dual or triple citizenships will not change his or her US citizen status for purposes of these rules.
Who Pays What?
In addition to complexities added because of having a nonresident alien spouse, other tricky areas require special attention when transferring property at divorce. Divorcing spouses should pay special attention to whether the asset transferred will yield US-source income taxable to the NRA spouse if he or she takes that item of property. If the parties are dividing property that includes a US rental property, US stocks or US debentures, for example, the question of how the income (e.g., rental, dividends, interest) will be taxed should be considered. Generally, the US rent is taxed either at graduated rates on a net basis or through 30% withholding at source; US dividends are usually taxed at a 30% or lower treaty rate at source and US interest may be tax-free if it qualifies as “portfolio interest” and proper documentation is in place with the US payor. Proper tax advice should be undertaken to ensure the properties are divided up in the most tax-efficient manner.
The concept of “basis” or “cost basis” is very important. For purposes of the US tax laws, “basis” is the original cost of property, adjusted for certain factors such as depreciation. When property is sold, basis is a key determinant in the taxpayer’s calculation of US income tax due. The taxpayer pays taxes on a capital gain (or takes a capital loss) that equals the “amount realized” on the sale (usually this is the sales proceeds) minus the sold property’s” basis”.
The parties should be very cautious about which assets they agree to keep, give or take in the property settlement. They should seek proper counsel for assistance in examining the US tax bill inherent in the assets they agree to take or keep in a divorce settlement. For example, assume each of the US and NRA spouses own an equal amount of US stocks acquired during the marriage and having a basis of $15 per share but with a current market value of $65 per share. Upon a later sale, the US spouse will pay US Income tax on the gain of $50 per share. Due to a special tax law exception for sales of US stocks by NRAs, no US income tax will be due on that gain when the stock is sold by the NRA spouse (assuming the spouse does not have significant physical presence in the US in the year of the sale). However, if the couple owns US rental properties, different considerations come into play. The property will have been depreciated and will have a lower basis as a result. Further, a sale of that property by either the US or non-US spouse will result in US tax on the gain.
In addition, the parties must ensure in writing that each will agree to provide access to all records that will permit proof to the IRS of the cost or adjusted basis of each asset.
Basis of Asset Received in Divorce Settlement
If the rules of Code Section 1041 apply giving tax-free treatment to the transferor-spouse, an asset received in a property settlement will be taken by the transferee-spouse with what is called a “carry-over” basis (the transferee takes over the transferor’s basis in the property). This carry-over basis rule applies to all property received by way of “gift”. Since the rules of Section 1041 do not apply when property is transferred to a nonresident alien spouse, this carry-over basis rule may possibly not apply when the recipient is a NRA. Perhaps the recipient spouse should be viewed as releasing marital rights or other valuable consideration in exchange for the property received, with the result that the recipient will take a basis equal to the fair market value of the property received.
Divorces involving dual national couples when one is a non US citizen require extra care and attention to detail for many reasons. This is especially true of the US tax issues involved in such cases. Professional assistance is your best bet.
Posted February 5, 2019
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