Section 1041 Explained: Tax-Free Spousal Property Transfers

What Is Section 1041?

Section 1041 of the Internal Revenue Code that mandates that any transfer of property from one spouse to another is income tax-free. No deductible loss or taxable gain can be declared. This section applies to transfers during marriage as well as in the divorce process. Section 1041 was enacted in order to simplify the consolidation of marital assets.

Explanation of Section 1041 Provisions

Section 1041 does not apply to transfers to nonresident-alien spouses and certain transfers of mortgaged property between trusts or transfers of U.S. savings bonds. This section also places the tax burden on the recipient of any transfer of marital property incident to a divorce (the property is treated as a gift); therefore, it can be in the interest of a divorcing spouse to negotiate for assets that have minimal taxable appreciation.

Practical Application of Section 1041 Rules

The rule applies beyond just property. The IRS provides this example: If a husband transfers a fishing permit, which has a basis to the husband of $100,000, to his wife, there will be no gain or loss on the transfer. In addition, the wife's basis in the fishing permit will be the same as the husband's basis, or $100,000. The wife's basis in the permit will be $100,000 regardless of the amount she may have paid to the husband for the permit (assuming the transfer was in the form of a sale as opposed to a gift).

In the case of divorce, the property is considered incident to the divorce if the transfer occurs within one year after the date on which the marriage ceases, or is related to the cessation of the marriage.

In cases of transfers in trust where liability exceeds the cost basis, the no-gain, no-loss rule is set aside to the extent that the sum of the amount of the liabilities assumed, plus the amount of the liabilities to which the property is subject, exceeds the total of the adjusted basis of the property transferred.

If the spouse (or former spouse) of the individual making the transfer is a nonresident alien, the tax-free exemption doesn't apply.

Section 1041 doesn't speak to the tax consequences of asset transfers involving the right to receive income, such as the transfer of a bond or CD and accrued interest yet to be paid, and contingent fees or deferred compensation, notes tax attorney David Klasing. In addition, a qualified domestic relation order overrides Section 1041 in the distribution of assets such as pensions and retirement plans.