Can Have Spouses Seeing Red
The Family Home
If the settlement calls for Use and Possession (U&P) of the family home where one of the spouses is going to remain in the home for an extended period of time, there is no need for an appraisal or other method of value determination. Critical considerations in this arrangement are:
- Who will be making the mortgage payment?
- Will the payment be considered alimony?
- If it is alimony, what is deductible?
- How will ongoing maintenance be paid for?
- How will the settlement proceeds be divided at settlement?
The general tax rule for obtaining the capital gain exclusion of $250,000/$500,000 requires that the owner/seller use the home as his or her principle residence 2 out of the last 5 years prior to the sale. There is a special exemption for divorcing spouses in a U&P situation that allows the out-spouse to secure the exclusion.
There are two surprises that can surface if the family home is sold. First, the gross proceeds of the sale will be reported to the IRS as being 50/50 to each spouse, no matter how the net proceeds are configured at settlement or thereafter. The adjustment for any variation in a 50/50 split needs to be reflected on the spouse’s individual tax returns. Second, if there was an equity buyout prior to the sale, the seller’s basis is the original cost (no increase for buyout cost) and the major improvements with the capital gain exclusion being $250,000.
Divorce and Rental Property
Before 2009, rental properties could provide a safe tax haven for couples going through the divorce process. One spouse could move into a former rental, use it as a residence for two years, and then claim the capital gain exclusion available for sales of qualified personal residences. Although use of the house as a rental prior to January 1, 2009 does not enter into the calculation, you must now include the period of time that the house was a rental in calculating the capital gain exclusion. For example, let’s say that you had a rental for years 2010-2013 and converted it to your personal residence in 2014. When you sold it in 2016, you would receive 33.34% ($166,667) of the capital gain exclusion as follows: Total years owned and rented since 2009 = 4; total years owned prior to sale, 2010-2015 = 6; 4/6 (2/3) of the years owned were rental years, therefore you would only receive 1/3 of the capital gain exclusion. You could end up paying capital gains tax and ordinary income tax depending upon how much depreciation was claimed prior to the sale (see next section).
“Surprise,” Depreciation Recapture
For this paragraph, depreciation is used to describe the expensing of property over its useful life, according to IRS regulations.For instance, when you purchase rental property, the building cost (not the land component) must be amortized over 27.5 years. For example, if the total purchase is $150,000 and the allocated cost of land is $30,000, you will be able to list $4,364 as a depreciation expense each full year that you own and operate the property as a rental. So let’s say that during the year, you collect $15,000 in rental income and pay out $10,000 in expenses. You would theoretically have $5,000 in your bank account. Your tax return would show net income of $636 of income and the resulting tax would be negligible. Is America great or what!
So after ten years (when your sell) of taking this depreciation totaling $43,640, it is now time to “pay the pauper.” Instead of the total gain being taxed at the capital gain tax rate, this depreciation recapture is taxed at 25%. This additional tax bite is of crucial concern to the spouse keeping the property in the divorce settlement as it should be included in the valuation of the property.
Owners of rental properties may have annual losses that cannot be deducted on their tax returns. These losses accumulate, attach themselves to the property that generated the loss, and are deducted when the property is sold.They can represent some serious tax savings to the spouse that keeps the property and cause a very inequitable property division to the other spouse if not considered in the valuation.
As seen above, divorce and real estate can provide either or both spouses significant tax issues and unseen challenges to an equitable property division. Is it worth the cost of an hour consult with a financial divorce specialist to avoid or minimize the impact of these transactions?
John Faggio is a CPA, CFP®, and Certified Divorce Financial Analyst™. Faggio Financial was established in 2004 to help divorcing individuals make the wisest decisions possible in this life changing event. We believe that this only be done with full disclosure of the financial facts, independent analysis, ongoing support, and teamwork with other divorce professionals that may be involved in your case.
For a more positive outcome in your divorce, email or call John Faggio today at 410-988-7333 for an initial, flat-fee consult.