After several years of a difficult marriage, Donald and Marlaagreed to a divorce

Question

After several years of a difficult marriage, Donald and Marlaagreed to a divorce. As part of the property settlement, Marlatransferred to Donald corporate stock, a commercial building, and apersonal residence. Donald transferred other property to Marla, butthe fair market value of the property was $600,000 less than thefair market value of the property Marla had transferred to him. Tomake the settlement equal, Donald agreed to pay Marla $600,000,payable over 10 years at 8% interest. For several years, Donalddeducted the interest on his Federal income tax return asinvestment interest. Upon audit, the IRS disallowed the interestdeduction, classifying it as nondeductible personal interest.Donald believes the interest is deductible and has asked you tofind support for the deduction. Write a letter indicating yourfindings to Donald Jansen, 104 South Fourth Street, Dalton, GA30720.

Explanation / Answer

When couplesdivorce, their property is generally split equally between them.But often, the couple has a balance sheet that doesn’t easilydivide. If one spouse wants to keep more assets than the other, andhas no source of funds to equalize the division, he will give hisspouse a promissory for the difference. The note is for the amountof the amount needed to equalize the division of property, andusually provides for payments of principal plus interest at areasonable rate.

A recent court caseclearly has established that the interest paid to the ex-spouse istaxable to her, even though the principal on the note is exemptfrom tax as a transfer incident to divorce (Gibbs, TC Memo1997-196). So if the recipient has to pay tax on the interest, thepaying spouse should receive a corresponding deduction on hisincome tax return, right? Not necessarily. Until recently, the IRShas ruled that divorce-related interest is non-deductible personalinterest, and has disallowed any deduction for it.

Several court caseshave sided with the taxpayer and against the IRS. John Seymour gavehis wife Katherine a promissory note for $625,000 in exchange forher interest in their business and marital residence. The note waspayable over ten years with 10% interest per year. The note wassecured by a mortgage on the residence.

The IRS disallowedall the interest, but the Tax Court ruled that the interest shouldbe allocated among all the assets John received from Katherine inthe divorce. Thus, a portion of the interest was deductible as homemortgage interest, and much of the rest was deductible asinvestment interest on the acquisition of the business and businessreal estate. (Seymour, 109 TC No 14 (1997).

In another case,Ronald Armacost gave his wife Linda a 20-year promissory note for$250,000, payable with interest at 10%. The note was secured by theproperties Ronald received from Linda. Once again, the IRS saidthat the interest was not deductible by Ronald, since divorce has apersonal rather than a business purpose. The Tax Court, followingSeymour, said that the IRS was right to disallow the deduction onlyto the extent the note was to acquire Linda’s non-investmentproperty. But the Tax Court determined that most of the note wasgiven to acquire investment property, so it allowed Ronald adeduction for most of the interest as investment interest.(Armacost, TC Memo 1998-150).

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