Do you realize when you have to recognize income?
Realization and recognition are separate concepts in US tax law, and realization is required for recognition. For example, say the per share price of a publicly traded stock you own increases after you buy it. You have unrealized gain that’s not recognized or taxed. You might think of this as a “paper” gain because you have not actually received the increase, you merely have the potential opportunity to receive it.
When you sell the stock, you realize the gain—you have increased your economic position due to the stock sale. In this example, the gain you realize is also recognized. That’s another way of saying it becomes taxable, so you have capital gain to report on your federal income tax return.
Though the general rule is that all realized gain is recognized gain (Section 1001(c)), you can sometimes postpone the income tax consequences. This happens under the “nonrecognition” sections of the internal revenue code such as section 1041, which applies when you transfer property to your spouse (with some exceptions, such as when your spouse is a nonresident alien).
Note that these sections differ from provisions in the code that exclude income. The purpose of nonrecognition provisions is to distinguish formal changes from economic ones while exclusion provisions typically remove certain income from taxation. For instance, the value of gifts and inheritances you receive are excluded from gross income (though the income produced by the property afterward is not).
In T.C. Memo. 2015-89 (Hughes), the taxpayer, a CPA, transferred stock to his current wife. He had no basis in the stock, and he gave it to his wife in December 2000 and January 2001 under a “gift deed.” He received nothing in exchange for the shares and made the transfer because he feared his former wife would re-open an agreed-upon divorce settlement once the shares were sold. At the time of the transfer, the taxpayer was a US citizen and a resident of the United Kingdom. His current wife was a UK citizen. Both the taxpayer and his current wife became US residents in 2001.
The taxpayer believed the share transfers were taxable to him because his current wife was a nonresident alien. Under section 1041, when a spouse to whom a transfer is made is a nonresident alien, the nonrecognition provision does not apply. (Note that the taxpayer wanted this outcome because he had no basis in the shares and if the transfers were taxable to him his wife would then have basis. Otherwise she would receive his transferred basis of zero.)
The taxpayer’s argument is that he had a realized gain. Since the nonrecognition provision (section 1041) did not apply, the realized gain must be recognized, giving his wife basis.
The IRS agrees the section 1041 nonrecognition does not apply, but says the transfers were a gift. Since no gain is realized on a gift, there is no gain to be recognized.
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Section 1041(a) provides for nonrecognition on interspousal transfers, and section 1041(d) provides that section 1041(a) does not apply where the transferee spouse is a nonresident alien.
When a nonrecognition provision does not apply to a transaction, recognition is not automatically required. Other nonrecognition provisions may apply, or the transaction may be one in which no income is realized, as is true with regard to the donor when the transaction is a gift. The foregoing principles represent fundamental premises of income taxation.
Where, as here, an interspousal property transfer takes the form of a gift, no gain is realized, so there is no gain to be recognized. No income tax is imposed on either donor or donee because neither party realizes income from the gift.
Under the Code, the gifts were not taxable events for income tax purposes.
Note: This case presents other issues not discussed here.