@asarbuckle
The divorce settlement does not necessarily have any impact on your tax situation. It is a completely independent document. If you were audited for some reason, the divorce document is one factor that an auditor might take into account. However, I assume that you were required to produce a gift letter for the mortgage lender. That would also be taken into account. and of course, audits are very rare.
If we assume this was a loan all along, then:
The IRS assumes that taxpayers will conduct their affairs in a businesslike manner, and this includes charging interest on loans. The interest is taxable income, but the return of the loan principal is not. If you don’t charge interest, the IRS requires that you report “imputed interest“, this means that you report income equal to the amount of interest you could have received if you charged interest, even though you didn’t charge interest. You must use at least the minimum applicable federal interest rate, or AFR. This is a variable rate that is currently between 4% and 5%, depending on the term of the loan, but it has been much lower in the past.
Let’s assume you made the loan when the AFR was 3% and interest is compounded annually. That would mean that you would be required to report $480 of interest income for every year that the loan balance was outstanding. When the home is sold, you don’t report the return of the principle as income.
If the facts of your situation, independent of the divorce settlement, are that this was a gift, then it was not reportable, and no tax was owed when you made the gift, and there is no income to report when the gift is returned to you, because that would simply be a separate gift from your son to you.
If the facts of the situation are that this was a loan, then you would be required to report imputed interest on your tax return using the AFR that was in effect when the loan was made.
If this was a true gift, you can treat it as a gift and follow the appropriate procedures. In the unlikely event you are audited, you can show documents that the money was a gift. If an auditor looks at the return of the $16,000 and determines that based on the weight of the evidence that it was a loan, then the consequence to you are that you would file some amended tax returns to report imputed interest income and pay a small amount of income tax plus late fees.
What I am much more concerned about is why does the divorce settlement indicate this money was a loan? Where did that information come from, and why did the attorneys and the spouses both agree to this if it was not originally true? I can't think of any legitimate reason for the parties to agree this was a loan if they both knew it was a gift.
