Avoiding Tax Pitfalls in New York Real Property Transfers in Separation and Divorce

Most divorces involve the transfer of a marital residence between the parties as part of equitable distribution, especially when there are minor children who will continue to reside in the family home. In the typical situation, the custodial parent becomes the sole owner of the property when the settlement agreement or divorce judgment is implemented. Other options include continued joint ownership with an event or a time when a sale is required.

There is a transfer tax payable on the transfer of real estate, including the marital residence, in connection with the implementation of the marital settlement agreement or divorce. The New York Real Property Transfer Tax is imposed by 20 NYCRR § 575.11(a)(10). If the property is in New York City, there is also a New York City Real Property Tax, imposed by Section 23.03(d)(3) of Title 19 of the Rules of the City of New York. This additional transaction expense is often overlooked, or discussion of it delayed, until after the parties have negotiated the settlement agreement, and after the time where there is any opportunity to avoid the transfer tax.

Real estate transfers in divorce and separation have other federal and state tax consequences as well. With appropriate planning, the parties can address the tax consequences to their mutual benefit. Without planning, the divorce will cost more than it needs to, because of additional taxes the parties will need to pay, both at the time of the transfer and later, when the remaining owner sells the property.

No Income Tax Consequences

Typically, the primary real estate asset in divorce is the marital residence, which is usually owned jointly by the married couple. Often, the spouse who is going to get the home will need to pay something or give up something to compensate the other party for the equity being relinquished. (The alternative — continuing joint ownership until a sale to a third party — has its own issues, which are beyond the scope of this article.)

Under the Internal Revenue Code, a person can treat as tax-free up to $250,000 of gain from the sale of his/her principal residence, if it was used as such for at least two of the five preceding years. Married individuals filing jointly can exclude up to $500,000 of gain. If the parties continue to own the martial residence until sale to a third party, even the non-resident spouse may use the $250,000 exclusion.

Regulations adopted by the Internal Revenue Service have liberalized the “2 out of 5 years” requirement for sales. The regulations allow the tax-free treatment even if the “2 out of 5 years” requirement is not met, if the home is being sold because of (among other things) divorce or legal separation.

If one spouse or former spouse transfers his/her interest in the marital residence to the other, pursuant to a divorce decree or marital settlement agreement, neither party realizes any gain or income, even if there is an equitable distribution payment made to equalize the parties' marital assets. The party paying the money or giving up another asset in equitable distribution does not get a “step-up” in basis because of the equitable distribution payment, but rather takes the basis of the transferring spouse. The Internal Revenue Code treats the transfer as a “gift,” but without affecting the “unified credit” that shelters estates and gifts from taxes. The recipient takes the “basis” or “cost” that the transferor had in the property that was transferred, and is responsible for any gains on that “basis” or “cost.”

Transfer Taxes Are Another Matter

There are no income tax consequences under New York law with respect to non-realty transfers between spouses or former spouses incident to divorce. However, a transfer of “real property” (a house, condominium, co-op) incident to divorce or a settlement/separation agreement requires that a real property transfer tax be paid.

The New York City Real Property Transfer Tax (NYCRPTT) ranges from 1% of the “consideration” to 1.425% for property where the “consideration” is more than $500,000. For property in other parts of New York, under the New York State Real Property Transfer Tax (NYSRPTT), the tax is $2 for each $500 of “consideration.”

The “Instructions for New York State Tax-Form TP 584” do not specifically mention transfers incident to a separation agreement or divorce. The Instructions do, however, exclude transfers in connection with a devise, bequest or inheritance. This specific exclusion and case law result in the conclusion that transfers incident to a divorce or separation agreement are transfers for “consideration,” and subject to this tax.

The “New York City Instructions for Tax Form NYC-RPT” are more explicit with respect to transfers incident to divorce or separation agreements. Those instructions state:

Marital Transfers. The total consideration for a transfer pursuant to a marital settlement or divorce decree includes the value of any marital rights exchanged for the property or economic interest therein plus any consideration paid by the grantee [transferee] for the transfer. The value of such marital rights should be listed on line 10 of this schedule. The total consideration is presumed to equal the fair market value of the portion of the property or interest therein that is being transferred. Attach a rider explaining how you determine the total consideration. (emphasis supplied)

An Example

In this discussion, we will assume that a husband and wife own a home (whether a house, condominium or co-op) jointly. If the home cost $100,000 (assuming no mortgages or improvements), and is worth $450,000 at the time of the transfer, the parties may adjust their equitable distribution based on the current $450,000 value (each party having an equity of $225,000). However, when the sole owner sells the house, his/her “basis” or “cost” will still be $100,000. The fact that he/she gave up some other asset, took a reduction in maintenance or paid money to adjust for the other party's equity of $225,000 in the house will not increase the owner's “cost” or “basis.” So when this $450,000 home is sold by the remaining sole owner (assuming a single personal tax return), there will be a gain of $350,000 (the $450,000 sales proceeds, less the basis of $100,000). (For ease of discussion, we have ignored the costs of the sale, such as brokers' fees or other expenses, and assumed that the net proceeds of the sale are $450,000.) The home sale exclusion of $250,000 in gain will not protect the entire gain of $350,000, and will still leave $100,000 of the gain subject to tax: In negotiating equitable distribution, the parties should be aware of the possible prospective tax liability to be incurred upon a future transfer of the home. In describing equitable distribution in the parties' agreement, it is not always appropriate to connect the payments or transfers between spouses to specific assets. For instance, you need not provide that the husband is transferring his one-half interest in the $450,000 home to the wife, and the wife agrees to pay the Husband $225,000 for that transfer. While the two items may be related, the relationship is irrelevant. Even if no payment were being made, the NYCRPT would apply and the transferor would be liable for a 1% tax on $225,000 ($2,250), plus NYSRPTT of two dollars for every $500 of consideration ($900 in taxes). Because these transfers are implemented after a settlement agreement is reached, many settlement agreements and divorce judgments do not include a provision for paying the real property transfer taxes. Under those circumstances, the transferor becomes primarily liable for the tax, which must be paid when the property is transferred; and the transfer is recorded in the appropriate office, or reported on the necessary transfer tax forms. The problem will become ripe when the tax is assessed, if it was not paid simultaneously with the transfer. In addition, interest (and possibly penalties) will apply because of the failure to file the appropriate transfer tax forms. Both the state and city rules provide that the transferee will be liable, jointly and severally with the transferor, if the taxes are not paid by the transferor. Proper planning should address this cost in the negotiations.

The transfer tax forms can be found online at http://on.ny.gov/2dNCXEF and http://on.ny.gov/2dHH7.

One Caveat

Although we have urged that one approach to avoid this additional transfer tax burden is to transfer the interest in the property before a settlement is reached, it now appears that the New York City Department of Taxation has taken a position that such a transfer made during negotiations and before an agreement was signed can be deemed as a transfer incident to a subsequent agreement or divorce. This position is based on the specific facts of the case and may not affect all pre-agreement transfers.

This case will wend its way through the system and we expect that it will clarify how the transfer tax law will be applied. There is no bright line in time before an agreement is signed, which would assure that the tax is not assessed.

We have found no cases that address this issue directly. It is very likely to be fact sensitive and may depend on how far away the settlement agreement was from the date of the actual real property transfer. It may be that a pending case will answer the question, sooner or later.

Conclusion

Pre-settlement transfers between negotiating spouses are not unusual. Under New York law, a transferring spouse will be protected in subsequent divorce proceedings, even if he/she signs away title to the soon-to-be former spouse, as the Domestic Relations Law diminishes the importance of legal title in determining equable distribution. Transfers of title frequently occur when parties are doing estate and tax planning. They may have an opportunity to avoid the transfer tax trap that has frequently caught parties after all the details have been concluded. If the purpose is to avoid the real property transfer tax, be forewarned that there may be a challenge, and the cost of defending the challenge may exceed the tax itself.

***** Eli Uncyk is a partner of Kamerman, Uncyk, Soniker & Klein, P.C. in New York City where his practice includes mediation, litigation, alternative dispute resolution, family law, tax and estate and business matters. Jeffrey S. Kofsky is also a partner with the firm, concentrating his practice in litigation in family law and Federal and State civil and commercial matters.