106 / What are the income tax results when an individual transfers an existing life insurance policy to or purchases a policy for the individual’s former spouse in connection with a divorce settlement?

No gain generally is recognized by the transferor if an existing policy is transferred to a spouse, or former spouse incident to a divorce, after July 18, 1984, unless the transfer is pursuant to an instrument in effect on or before such date or the transfer is, under certain circumstances, in trust.

When no gain is recognized, the transferee will be treated as having acquired the policy by gift and the transferor’s cost basis for the policy (net premiums paid) is carried over to the transferee.¹ As a result, any such transfer of an existing policy will not cause the death benefit proceeds to be includable in the income of the transferee under the transfer for value rule ( Q 79) due to the “basis exception.” A transfer is incident to a divorce if the transfer occurs within one year after the date the marriage ceases or is related to the cessation of the marriage.² Thus, a transfer of property occurring not more than one year after the date on which the marriage ceased need not be related to the cessation of the marriage to qualify for Section 1041 treatment. A transfer of a policy is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument and the transfer occurs not more than six years after the date on which the marriage ceases.³

If property is transferred in trust for the benefit of the spouse or former spouse, however, gain will be recognized by the transferor to the extent that the sum of the liabilities assumed plus the amount of liabilities to which the property is subject exceed the total of the adjusted basis of all property transferred. Therefore, when a policy with a loan is transferred in trust, gain will be recognized to the extent the total liabilities of all property transferred to the trust exceed the total basis of all items of property transferred. When gain is recognized on a transfer in trust, the transferee’s basis is adjusted to reflect the amount of gain recognized by the transferor. Payments from an insurance trust to which the property is transferred for the benefit of a spouse or former spouse will be taxed to the spouse or former spouse as a beneficiary and not taxed as alimony.⁴

Both spouses or both former spouses may elect to have these rules apply to all transfers after 1983 and also may elect to have these rules apply to transfers after July 18, 1984, under divorce or separation instruments in effect before July 19, 1984.