INDIVIDUAL WHO TRANSFERS U.S. SAVINGS BONDS TO FORMER SPOUSE UPON DIVORCE MUST INCLUDE DEFERRED, ACCRUED INTEREST IN GROSS INCOME.

Rev. Rul. 87-112

ISSUES

(1) If a taxpayer transfers United States savings bonds to the taxpayer's spouse or former spouse in a transfer described in section 1041(a) of the Internal Revenue Code, must the taxpayer include the deferred, accrued interest on the bonds in gross income in the year of the transfer?

(2) What is the basis in the bonds of the taxpayer's spouse or former spouse immediately after the transfer of the bonds?

FACTS

A, an individual who uses the cash receipts and disbursements method of accounting, held Series E and EE bonds with maturity dates after 1985. The bonds were registered in A's name and purchased entirely with A's funds. A had not elected pursuant to section 454 of the Code currently to include in income any interest accrued on the bonds. In taxable year 1985, as part of a divorce property settlement, A transferred the bonds to B, A's former spouse. B redeemed the bonds in 1986.

LAW AND ANALYSIS

Section 61(a) of the Code provides that, unless otherwise excluded by law, gross income means all income from whatever source derived, including interest.

Under section 454(c) of the Code and section 1.454-1(a) of the Income Tax Regulations thereunder, if a taxpayer holds a United States saving bond issued at a discount and redeemable for fixed amounts increasing at stated intervals, the increase in redemption value is includible in gross income as interest income for the taxable year in which the bond matures, is redeemed, or is disposed of, whichever is earlier, unless the taxpayer elects under section 454 to report this interest income in the years in which increments in the redemption value of the bond occur.

Under section 1.454-1(a)(1) of the regulations, an owner of Series E bonds may elect to report the increment on these bonds each year. This election is exercised by reporting as interest income, with respect to bonds owned at any time during a taxable year, the increments that occurred in taxable years up to and including the taxable year for which the income is reported. The same rules are applicable to Series EE bonds.

Section 1041(a) of the Code provides that no gain or loss will be recognized on a transfer of property from an individual to (or in trust for the benefit of) (1) a spouse, or (2) a former spouse (but only if the transfer to the former spouse is incident to the divorce). The effect of section 1041 is to defer the tax consequences (recognition of gain or loss) until the transferee disposes of the property.

Although section 1041(a) of the Code shields from recognition gain that would ordinarily be recognized on a sale or exchange of property, it does not shield from recognition income that is ordinarily recognized upon the assignment of that income to another taxpayer. Because the income at issue here is accrued but unrecognized interest, rather than gain, section 1041(a) does not shield that income from recognition. The transferred bonds in the present situation contain an interest element that has not been included in income. Accordingly, the specific rule of section 1.454- 1(a) of the regulations for dispositions of interest-deferred obligations applies to require that the transferor include the accrued interest in income in the year of the transfer. See Rev. Rul. 55-278, 1955-1 C.B. 471 (interest accrued on bonds prior to reissue to transferee includible in transferor's gross income for taxable year in which gift made), and Rev. Rul. 54-143, 1954-1 C.B. 12 (transferor recognizes interest accrued on bond upon transfer of interest in bond to daughter).

Section 1041(b)(1) of the Code provides that, in the case of any transfer of property described in section 1041(a), for purposes of subtitle A, the property will be treated as acquired by the transferee by gift. Section 1041(b)(2) provides that, in the case of any transfer of property described in section 1041(a), the basis of the transferee in the property will be the same as the adjusted basis of the transferor. In general, section 1041(b)(2) is intended to operate in the same manner as section 1015(a), which applies to property acquired by gift in transfers not described in section 1041(a). The difference between the two provisions is that under section 1041(b)(2) the carryover basis rule applies to property having a fair market value less than the transferor's basis as well as to property having a fair market value equal to or greater than the transferor's basis. See section 1.1041-1T(d) of the Temporary Income Tax Regulations under the Tax Reform Act of 1984.

Rev. Ru. 79-371, 1979-2 C.B. 294, considered the donee's basis under section 1015 for an installment note in a situation where the donor's transfer of the note to the donee resulted in the recognition of gain to the donor. The gain was required to be recognized under the former version of section 453B(a) and (b) of the Code (section 453(d)(1) and (2) of the Code as in effect immediately prior to the enactment of the Installment Sales Revision Act of 1980, 1980-2 C.B. 489). Under section 1015(a), the donor's basis in the installment obligation at the time of the gift became the donee's basis in the installment obligation. That revenue ruling holds that for this purpose the donor's basis is increased to include the gain resulting from the disposition. Accordingly, in the instant case, immediately after the transfer the transferee's basis in the bonds is the sum of the transferor's basis in the bonds immediately prior to the transfer plus any income recognized by the transferor under section 1.454-1(a) of the regulations as a result of the transfer of the bonds.

HOLDING

(1) The deferred, accrued interest on United States savings bonds is includible in the transferor's gross income in the taxable year in which the transferor transfers the bonds to the transferor's spouse or former spouse in a transfer described in section 1041(a) of the Code. The deferred, accrued interest from the date of original issuance of the bonds to the date of transfer of the bonds to B is includible in A's gross income. Only the deferred, accrued interest on the bonds from the date of the transfer to the date of redemption of the bonds by B is includible in B's gross income. See Rev. Rul. 54-143.

(2) The transferee's basis in the bonds immediately after the transfer is equal to the transferor's basis in the bonds increased by the interest income includible by the transferor as a result of the transfer of the bonds.

DRAFTING INFORMATION

The principal author of this revenue ruling is Vernon S. Carter of the Individual Tax Division. For further information regarding this revenue ruling contact Mr. Carter on (202) 566-4840 (not a toll- free call).