Tax and Support Consequences of Making Equalizing Payment in Installments

By George H. Norton, of Counsel, Lakin ·Spears, and Garrett C. Dailey, President, Attorney's Briefcase, Inc.

Reproduced from commentary in Lawgic's California Marital Settlements

Summary: Upon dissolution of a marriage, if one spouse receives more than half of the community property, that spouse may agree or be ordered to pay the other spouse for the difference. If this "equalizing payment" is made in installments, consideration should be given to the potential support and tax consequences flowing from the payment of principal and interest.

If an equalizing payment on the division of community property is to be made in installments, e.g., payments on a note, you should consider the income tax and support effects of these payments. The interest portion received will be includible in the income of recipient spouse for federal tax purposes. (Gibbs v. Commissioner (1997) T.C.Memo 1997-196.) However, as discussed below, it may also be deductible to the paying spouse. In either case, the result can have an effect on child and spousal support paid.

Among the considerations relating to the effect of interest payments from equalizing promissory notes on support obligations, are the following. While it will often cause a significant reduction to the paying spouse's cash flow, it is usually unfair for one spouse to retain the community property and then use payments on that buyout to reduce support payments to the other spouse. (See In re Marriage of Martin (1991) 229 Cal.App.3d 1196, 1201, 280 Cal.Rptr. 565 (a spouse "may not finance a 'buy-out' of community property and then successfully claim inability to pay spousal support").) Likewise, the supported spouse will be receiving payments on the debt from the paying spouse. It must be remembered that, to the extent that the payments represent principal on the property settlement obligation, they are property and no different than if the principal received in the property division was invested in a brokerage account and periodically a portion transferred to another investment. While it would certainly be appropriate to consider the income or gain realized from the transaction, it would be unfair to consider the entire amount as available for support. The interest component should be considered income and factored into the support calculation. The principal portion clearly should not be.

The interest portion of the payments made by the paying spouse is presumptively personal interest and not deductible. (Int.Rev. Code §163 (h)(2).) However, if it can be shown that the interest is being paid to acquire the other party's interest in the family residence, then it is deductible as qualified mortgage interest pursuant to Int.Rev. Code §163 (h)(3). (Seymour v. Commissioner (1997) 109 TC No. 14, Tax Ct.Rep. (CCH) 52,336.) Likewise, if the interest is paid on a note used to acquire the other spouse's interest in business or investment property, then it is also properly deductible. (Armacost v. Commissioner (1998) T.C. Memo 1998-150.) Of course, the burden is on the taxpayer to establish that the amount of investment property which s/he received in the property division exceeded that received by the other party by twice the value of the note. If the values for the properties divided are not shown in the MSA, then it will be more difficult to meet this burden. Attorneys settling cases often refrain from including the values of the properties in the final MSA for many reasons, including not wanting them to be public record or believing that the failure to include them may make it harder to set aside the judgment. In these situations, the parties might choose to show the equal division of the assets other than the residence, business or other investment assets, and then set forth the value of the remaining property and state that the promissory note is specifically to equalize that asset. While this recital is not binding on the IRS, it does make the taxpayer's case far stronger.

The Armacost court defined investment interest as "any interest paid on indebtedness properly allocable to investment property. [Int.Rev. Code] Sec. 163(d). Investment property includes property producing gross income from interest, dividends, annuities or royalties not derived in the taxpayer's trade or business, or property held in the course of the taxpayer's trade or business which is neither a passive activity nor an activity in which the taxpayer materially participates."

If the equalizing payment is to be made in installments and the payments meet the requirements of Internal Revenue Code §71, they may be deductible to the paying spouse and taxable to the receiving spouse, even if they are intended to be payments to equalize the property division. (Nelson v. Commissioner (1998) TCM 1998-268, T.C.M. (RIA) 98,268.) To avoid this, you need to review the requirements of Internal Revenue Code §71, namely that, to be deductible:

(1) The payments must be made in cash.

(2) The payments must be made to or on behalf of a spouse or former spouse.

(3) The payments must be made pursuant to a judgment of dissolution, legal separation, written agreement incident to dissolution, written separation agreement, or temporary support order. [Hereafter referred to as "the instrument."]

(4) The instrument does not state that the payments will not be taxable to the recipient nor deductible to the payor.

(5) Except for temporary support orders, the parties must not be members of the same household when payment is made.

(6) There is no requirement that any payments be made after the death of the supported spouse, or any substitutes therefor.

(7) The payments may not be fixed as child support or subject to a contingency related to a minor child.

(8) A joint return is not filed.

(9) If the payments are front loaded, they are subject to recomputation. (Int.Rev. Code §71.)

To avoid having the payments be taxable to the receiving spouse, all that needs be done is to specify that in the Agreement that the payments are part of the property division and, as such, are not to be taxable to the recipient. In addition, a tax savings clause should be included.