Federal Tax Discrimination for Gay Divorces

Breaking up is hard enough to do, but it's especially painful when a court or the IRS doesn't honor your "marriage" at the time of divorce.
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Breaking up is hard enough to do, but it's especially painful when a court or the IRS doesn't honor your "marriage" at the time of divorce. One problem that received a fair amount of notice is where a cluster of local courts (in Texas most recently) have refused to grant a divorce, on the grounds that allowing a couple to get a court divorce was tantamount to recognizing their marriage. One might think that those who are against the notion of lesbian or gay couples marrying would be pleased to see them parting ways, and would reward them appropriately! Instead, one of the spouses now needs to relocate to a marriage-recognition state, and commence a divorce proceeding there.

A less frequently noticed problem - but one that affects even those couples who live in marriage-recognition states such as Massachusetts or California, involves the tax penalties on same-sex married couples. This is a serious problem, with only the glimmer of a possible (and quite limited) exception being for those who live in community property states and are dividing up community property assets.

Here is the story. In the old days transfers of property or assets between spouses when they got divorced sometimes were taxable, as income to the recipient, even when the one who had the asset originally had already paid taxes on the income that resulted in the asset (i.e. a savings account or a house). Then, more than fifty years ago, the United States Congress passed a law saying that any transfer between spouses "incident to divorce" would be non-taxable - and would not be considered a reportable gift either. Thus, if one spouse gets the entire house or a portion of his or her spouse's savings account. Moreover, if one if one spouse receives alimony after the divorce, the couple has a choice - either it is paid tax free, or better yet, the payor can deduct the payment and the recipient pays the tax on it, which usually is at a lower tax rate.

Gay divorces have none of these privileges. Even though the partners may be considered married under state law (either as married, domestically partnered, or civil union partners) and one of the partners may have to transfer properties or investment accounts or pay alimony to his or her ex, the spousal exemption from taxation does not apply to them. This can create serious trouble - especially because the IRS hasn't clearly stated what rules should be applied in this situation. Is it a gift, which could eventually result in a gift tax being owed by the one making the gift (and believe me, the one paying at time of divorce probably doesn't think of it as a gift!), or is it taxable income to the recipient (even though the one paying the money already paid taxes on it)? In either case, it's a potentially big burden. For more information on this problem, check out my new book, www.MakingItLegal.net

A recent IRS ruling has helped ease the situation a bit in community property states, such as California or Washington State. The IRS issued a "Chief Counsel Advisory" that said that community property income would be treated as joint income for income tax reporting purposes, even if the marriage or domestic partnership was not recognized as a marriage. Lambda Legal has issued an excellent summary of the ruling.

So far the rulings have only dealt with income tax reporting, so we don't know for sure what the IRS will do when it comes to a divorce. But if the IRS acts in a manner that is consistent with this position when it comes to divorce, the division of community property in equal portions to each spouse would be exempt from further taxation. In other words, the IRS would be recognizing that each party actually "owned" 50% of the community property, and so the distribution of it to each partner 50/50 is not a taxable transfer. However, this exemption does not apply to the majority of states that are not community property states (i.e. Massachusetts and the rest of the northeastern states) and only applies to community property assets, which are savings or property acquired after the marriage or registration date. Thus, for long-term couples who acquired assets prior to when they were allowed to register or marry, this benefit will only be of limited value.

And making matters worse, one more painful aspect of this situation is the sheer complexity of the problems - which can make it hard for gay or lesbian couples even to find a lawyer or accountant who knows the rules in this rapidly-evolving legal arena.

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