Impact of Divorce Decree on Debt Obligation

When couples divorce, they settle financial matters between themselves. For instance, one spouse may receive the family home and agree to make all future mortgage payments for this home. How do these financial agreements among the spouses affect other parties, such as the mortgage company?

In a recent case, a divorce decree said that the wife would assume her husband’s debt with Citibank. Later, Citibank, the creditor, forgave the loan-about $4,000. The IRS said the husband (and not the wife) was liable for cancellation of debt income and the Tax Court agreed.

A divorce decree shifting liability for a debt from one spouse to the other acts as an indemnification agreement; the spouse merely agrees to pay the other spouse’s debt. It does not alter the original loan or other contract between the parties (the original debtor and creditor). Thus, with respect to the creditor, the husband continued to be viewed as the borrower even though the wife had agreed to make payments on the loan, so he had the tax consequences from the debt forgiveness.

Note: The same results apply for tax liability on a joint return that is filed prior to a divorce. Often the divorce decree says one spouse or the other remains liable for all of the taxes on a joint return, but the IRS continues to have the right to collect back taxes from either spouse; the IRS is not a party to the divorce decree and does not consent to a change in payment responsibility.