ValueLinks Newsletter

October 2003

Interest is taxable to the Receiving Spouse
Stated interest received on a note issued with respect to a divorce is taxable income to the recipient spouse.  The Tax Court, in Cipriano [TC Memo 2001-157 (2001)], stated that interest paid is compensation for the delay in the receipt of marital assets to which the spouse was entitled as of the day of divorce and, therefore, is not eligible for nontaxable treatment under Section 1041 of the Internal Revenue Code.  In some instances, taxpayers may not include interest on the note.  Nonetheless, any obligation paid in periodic installments contains an interest component due to the time value of money.  This is referred to as “imputed interest”.  At present, the IRS has not taxed imputed interest on Equitable Distribution paid over time.  However:

In Craven [affirmed 215 F.3d 1201, 85 AFTR 2d 2000-2229] and Gibbs [TC Memo 1997-196, 73
TCM 2669 (1997)] the Tax Court maintained the non-taxable and taxable status of imputed and
stated interest, but the Tax Court indicated it could consider imputed interest on an Interspousal
Note.

Interest Paid by the Payer Spouse
Two cases, Seymour and Armacost, give us guidance here.  The IRS has argued that interest paid on a note to satisfy the terms of Equitable Distribution is nondeductible personal interest because divorce is a personal matter.  However, the Tax Court held that the deductibility of interest by the paying spouse is subject to the same tests to determine the type of interest as any other interest expense.  Generally, interest is deductible if it is incurred to acquire an asset used in a trade or business or for investment, or to acquire a principal residence.  This fact pattern leads us to interest tracing rules and an allocation of interest between assets acquired with the debt.  It appears that a portion of the interest will always end up being non-deductible personal interest, but there is some relief for the paying spouse.

Interest Tracing
In Seymour [109 T.C. 279, 1997] and Armacost [T.C. Memo 1998-150, 1998] the Tax Court looked to the interest tracing rules to determine whether interest paid by the paying spouse on an installment note was deductible interest.

What are Interest Tracing Rules?
Interest tracing rules require that interest on debt be allocated to the assets acquired with the debt.  There is no specific guidance on how to apportion the debt and corresponding interest when a number of assets are involved.  Some method based on a ratio of the fair value, book value or adjusted basis of assets acquired would appear reasonable.  For example:

John will give his spouse an installment note.  In return he will receive, as his share of equitable distribution:

Under the above allocation, based on Fair Value of Assets received, 46% of John’s interest is allocated to principal residence acquisition, 31% is allocated as investment interest and 23 % is non-deductible personal interest.