How does tax law treat property settlements when same-sex couples divorce?

Issues

Generally, property settlements in divorce are not taxable. But the federal government doesn’t recognize same-sex marriage — as far as the federal government is concerned, there was no marriage to begin with, so the typical rules regarding divorce and taxes don’t apply. Consequently, divorcing same-sex couples may face both income tax problems (in the form of capital gains) and gift tax problems in property transfers.

Example:

Angie and Alice are in a same-sex marriage in Iowa. They jointly own a house and are both on the mortgage. Angie and Alice get a divorce. The divorce settlement awards the house and the mortgage liability to Angie.

The house’s fair-market value is $160,000. The mortgage balance is $130,000. 

Because their marriage isn’t recognized, it appears that Angie and Alice have a tax problem.

Or do they?

Let’s tackle the gift tax issue first.

Gift Tax

For gift tax purposes, a gift takes place whenever someone gives something to someone for less than full consideration. In this case, it would appear that Alice has given a $15,000 gift to Angie — she’s given Angie a piece of property worth $80,000 (1/2 of the $160,000 value of the home) and received $65,000 of consideration in return (being released of 1/2 of the $130,000 mortgage balance).

$15,000 is above the $14,000 gift tax exemption, so it appears Alice is subject to gift tax on this transfer, right?

Not so fast.

DOMA Can’t Overrule Everything

There is no gift here, because Alice gave up ownership of the house as part of a legal settlement that releases her of her spousal obligations under state law.

The $15,000 difference between the “consideration received” (release of $65,000 mortgage obligation) and Alice’s share of the market value of the home ($80,000) is not a gift. Rather, she is being released of intangible marital obligations under state law. See the 1962 U.S. Supreme Court case of Davis v. United States (the part in parenthesis below is my alteration of a citation within the ruling; the rest is a direct quote):

Any suggestion that the transaction in question was a gift is completely unrealistic. Property transferred pursuant to a negotiated settlement in return for the release of admittedly valuable rights is not a gift in any sense of the term. To intimate that there was a gift to the extent the value of the property exceeded that of the rights released not only invokes the erroneous premise that every exchange not precisely equal involves a gift but merely raises the measurement problem discussed in (a part of the ruling).

Capital Gain

Angie may have a capital gain here, though, depending on what her basis in the property is compared to $80,000. Whether this gain is taxable or not depends on how long Angie owned and lived in the home.

Beware if Truly Unmarried

Angie and Alice are not subject to gift tax because they were married under state law, and the marital obligations were dissolved and property was split in accordance with a court order under state law. This is true even though the federal government doesn’t recognize their marriage.

But if Angie and Alice were truly unmarried, there would be a gift tax issue. This is true regardless of sexual orientation. So this would apply to opposite-sex, boyfriend/girlfriend couples who own property together and then break up and need to split up property.

“This blog post, along with comments that may follow, should not be considered tax advice. Before you make final tax or financial decisions, please secure a professional tax advisor to give you advice about your unique situation. To secure Jason as your accountant, please click on the ‘Services’ link at the top of the page.”