By Anthony Diosdi
If you are divorcing or recently divorced, taxes may be the last thing on your mind. However, a divorce, in particular a cross-border divorce, may have a big impact on your finances. This article discusses some key tax tips to keep in mind if you are divorcing or recently divorced and you held assets located in the U.S. and abroad with your spouse.
Understand the Changes to the Tax Treatment of Alimony and Separation Payments
Prior to the enactment of the 2017 Tax Cuts and Jobs Act, if a spouse made payments under a divorce or separate maintenance decree or written separation agreement, the spouse was able to deduct them as alimony. This applied only if the payments qualified as alimony for federal tax purposes. If a spouse received alimony from a spouse or former spouse, the alimony was taxable in the receiving spouse’s income on the year it was received. If the spouse or former spouse receiving alimony was not a nonresident alien individual, unless a treaty applied a reduced rate, the payor of the alimony was obligated to withhold U.S. tax at a flat 30 percent from the alimony payments.
The rules governing the deductibility and taxation of alimony recently changed. For divorce agreements entered into after December 31, 2018, alimony payments are no longer tax deductible for the paying spouse and no longer taxable for the receiving spouse. In addition, alimony payments are no longer subject to U.S. withholding requirements. However, the alimony payments may be subject to income tax in the receiving spouse’s country of residence.
Determine the Best Way to Transfer Property
A divorce often involves the transfer of property between the divorcing spouses. The rules governing these transfers can be complicated. This is particularly true for nonresident alien spouses. Under Internal Revenue Code Section 1041(a), generally, no income tax is recognized in a transfer of property between spouses (or former spouses) incident to divorce if both spouses are U.S. citizens or residents. A transfer of property is incident to the divorce if such transfer occurs within one year after the date on which the marriage ceases, or is related to the cessation of the marriage. However, when either husband or wife are nonresidents, who own real estate, a single family home, for example, in the United States and are in the process of getting a divorce and dividing their assets, the general rule says that if the spouse (or former spouse) of the individual making the transfer is a nonresident alien, the transferor will have to recognize taxable gain upon transferring all or a portion of the property to the other spouse. For income tax purposes, the transferor will recognize the difference between the fair market value of the property and its adjusted basis. The transferee’s basis in the transferred property would be its fair market value on the date of the transfer.
The tax-free provisions of Internal Revenue Code Section 1041(a) does not apply to cases where a transferred spouse is a non-resident alien. In these cases, a transfer of U.S. property by a nonresident alien will trigger a U.S. income tax obligation.
Below, please see an example which illustrates the different tax treatment in property transfers incident to a divorce involving a nonresident transferee and a U.S. citizen transferee.
Assume a couple from Japan purchase a vacation condominium in Maui, Hawaii
for use for vacation purposes. Let’s also assume that this couple are citizens of Japan and are not U.S. citizens or U.S. residents. The couple decides to divorce and under their marital settlement agreement, the husband has to transfer his interest in the condominium to his former spouse. Because the transferee spouse is a nonresident alien, this property transaction is taxable at the time of the transfer.
The result is different in cases of real property transferred between U.S. citizens through a divorce. Let’s assume that a U.S. couple purchased a condominium in Park City, Utah which they use as a ski vacation home. The couple decides to divorce. Under their marital settlement agreement the husband will transfer his interest in the condominium to his former spouse at the time of the divorce. The Internal Revenue Code provides that no gain or loss is recognized on transfers of property if: 1) it occurs within one year after the date of the end of the marriage or 2) is related to a cession of marriage. A transfer of property is classified as “related to the cession of the marriage” if the transfer occurs pursuant to a divorce or separation instrument and occurs not more than six years after termination of the marriage. See IRC Section 1041. Because the transferee spouse is a U.S. citizen and the transfer occurred pursuant to a divorce agreement within six years after the termination of the divorce, it is not taxable under current U.S. tax law.
Another concern in cross border divorces is the Foreign Investment in Real Property Tax Act or “FIRPTA.” To ensure collection of the FIRPTA tax, any transferee acquiring a U.S. real property interest must deduct and withhold a tax equal to 15 percent (less in some cases) of the amount realized on the disposition. A transferee is any person, foreign or domestic, that acquires a U.S. real property interest by purchase, exchange, gift, or any other type of transfer. The amount realized is the sum of the cash paid or to be paid, the market value of other property transferred or to be transferred, the amount of liabilities assumed by the transferred, and the amount of liabilities to which the transferred property was subject. This withholding burden can easily fall on an U.S. citizen spouse or ex-spouse that is involved in the transfer of U.S. real property co-owned by a nonresident spouse or ex-spouse.
There are strategies to alleviate FIRPTA withholding in cases involving the transfer of U.S. real property where one or more of the spouses are not nonresidents. First, one spouse could gift U.S. real property to the other spouse. In 2023, a non-U.S.citizen spouse can transfer to his or her spouse up to $175,000 free of federal gift tax consequences. Besides the reduction of gift tax, another advantage of gifting real property to a spouse is the fact that under Internal Revenue Code Section 1041(a), FIRPTA may not apply and as a result there could potentially be no withholding of the 15 percent of the realized amount of the property. However, the exclusion discussed above only applies to property transfers that took place prior to the actual divorce.
Another potential strategy to mitigate or avoid tax on the transfer of real property between divorcing spouses would be to utilize an applicable estate and gift tax treaty or income tax treaty, if appropriate. If the divorcing spouses are not U.S. citizens but are residents of a country in which the U.S. has an estate and gift tax treaty, the treaty should be carefully reviewed. In some cases, an estate and gift tax treaty can be utilized to reduce or even avoid gift tax liabilities and income tax associated with the transfer of real estate through a marital settlement agreement. Certain estate and gift tax treaties in effect allow for tax-free interspousal transfers.
Income tax treaties may also mitigate the income tax consequences associated with the transfer of real property between nonresident spouses. Certain tax treaties have non-discrimination clauses that might alleviate an income tax on the transfer of property incident to a divorce agreement. For example, many tax treaties that the United States has entered into contain a non-discrimination clause. Typically, non-discrimination clauses provide that the United States cannot impose more burdensome taxes on citizens of the treaty country than it imposes on U.S. citizens who are in the same circumstances.
Family Obligations
Family obligations should always be considered in divorce. On many occasions individuals divorcing must provide financial support for family obligations that include medical care and/or fund the education of a child. Fortunately, the gift tax has never been considered applicable to one’s furnishing of food, clothing, or shelter for one’s dependent spouse and children. This was given express recognition in the proposed regulations released after the enactment of the 1954 Internal Revenue Code. These proposed regulations provided for “current expenditures by an individual on behalf of a spouse or minor child in satisfaction of one’s legal obligation to provide for their support are not taxable gifts.” See Prop. Reg. Section 25.2511-1(f)(1).
Although the current regulations do not include this statement, it is correct to treat the discharge of spouses’ or parents’ support obligations as considered in money or money’s worth, and the principle should continue to be recognized. Thus, a person’s payment of another’s unreimbursed medical expenses or academic tuition to an educational organization are not subject to the gift tax. See IRC Section 2503(e). Only payment of medical expenses that are not reimbursed by insurance or otherwise are eligible for the exclusion. And payments must be made directly to the one who supplies the services and not reimburse the one who has paid for the services.
Educational expenses that may qualify are likewise unlimited in amount. The exclusion applies to both full and part time students; but only “tuition” may be excluded. Payments for books, supplies, housing, and related items are outside the statute and may constitute taxable gifts. Again, to be excludable for gift tax purposes, payment must be made directly to an educational organization.
Conclusion
Given these complexities, any transfer of real property, property, or money in the context of a cross-border divorce or separation should be reviewed in advance by an international tax attorney with a strong background in international tax to determine the exact U.S. tax consequences of any transfer associated with a divorce.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.