When Bill and Jen decided to divorce, they never expected their personal residence to become a major problem. Initially, Jen thought she wanted to stay in the house. She was emotionally attached to the home, and she thought remaining in it would help minimize the impact of the divorce on the couple’s daughter, since the home was the only one their daughter had ever known.
But now, two years after they agreed to the divorce, it is still not final, because Jen is concerned about a decline in the home’s value and whether she can sell or refinance it if the mortgage and maintenance costs become too great a financial burden. They have not executed a separation agreement. Bill has not lived in the home for more than two years and is becoming more frustrated with his “temporary” status; he, too, would like the matter resolved. In truth, the home that provided a bright spot of enjoyment to them as a family has now become their mini “toxic asset.”
In the past, a divorcing couple usually considered the family home one of their more flexible assets. If one spouse wanted to keep and maintain the home, he or she could refinance and buy out the other spouse’s equity. If neither party wanted to stay in the home, it could usually be sold at a price close to their expectations within a few months, almost always without a tax issue. But the current housing and refinance market has changed this situation, and the personal residence now can be one of the more challenging aspects of a divorce.
Couples who purchased homes in the last few years may face nondeductible losses; however, those ending longer-term marriages could still realize a significant gain. In addition, the soft market is making it more difficult to determine the amount of gain (sales take longer, and appraisals are more difficult). It’s also more difficult to access the gain through a refinancing or an equity loan. As a result, CPAs can find themselves answering tax questions they never considered before.
SECTION 121 GAIN EXCLUSION
CPAs and their clients have become very comfortable with the principal residence gain exclusion under IRC § 121. Since Aug. 5, 1997, this section has allowed taxpayers to exclude up to $250,000 of gain on the sale of a principal residence where the ownership and use tests are met and there has been no sale or exchange of a principal residence to which the exclusion applied by either spouse within the pas two-year period.
Taxpayers filing a joint return may exclude up to $500,000. Generally, they must own and use the property as their principal residence for at least two years during the five years before the sale. For a joint return, to claim the full $500,000 exclusion limit, either spouse may meet the ownership test, but both must meet the use test unless a divorce or separation agreement grants only one spouse the use of the home.
Reduced exclusions are available for taxpayers who fail the two-out-of-five-year test because of a change in employment, health or other “unforeseen circumstances” (according to the IRS, such circumstances may include divorce and legal separation when under a decree of divorce or separate maintenance). In divorces, however, the simple rules of section 121 can become more complicated.
Bill and Jen’s first idea was to have Jen keep the home as part of the divorce settlement and pay Bill his portion of the equity when the home is sold or refinanced in the future. The transfer between them would be nontaxable under IRC § 1041, which deals with transfers incident to divorce. Neither of them would be responsible for taxes at this time, and after the transfer, Jen could continue to own the house for as long as they agreed. But the clock is ticking for this strategy (see sidebar, “Transfers Incident to Divorce: A Limited-Time Option,” below). If Jen keeps the house and later sells it, she would most likely be able to exclude up to $250,000 of gain under current law. If she were to remarry and she and her new spouse both satisfied the qualifying tests, they could be eligible for the $500,000 exclusion.
Jen, however, is reluctant to keep the home because she is concerned that it may continue to lose value and equity. Bill is also not in favor of this approach, since with the current market, it might be years before Jen could sell or refinance and provide him with his portion of the equity as well as remove him as a guarantor on the mortgage.
Bill and Jen have now decided to have Jen continue to live in the house while they look for a buyer and then sell the home and divide the equity. If the sale occurs before the year the divorce is final, they could report the sale on a joint return and exclude up to $500,000 of gain. If the sale occurs afterward, Bill and Jen might need a little planning to successfully exclude up to $250,000 each on their separate returns. If Bill has been out of the home for more than three years at the time of the sale, he would fail the use test (two out of five years); however, he could still exclude the gain, as there has always been a relief provision.
This provision—IRC § 121(d)(3)(B)—allows a taxpayer who moves out of the marital home to continue to count the time a spouse or former spouse is granted use of the residence by a divorce instrument. The key here is that a divorce or separation “instrument,” that is, an agreement, must be executed. Just moving out won’t work. With a divorce or separation agreement, as long as one spouse or former spouse meets the use test, both can meet the test.
Now, what about the ownership test? When filing a joint return, only one party needs to have been an owner for two out of five years (IRC § 121(b)(2)(A)). But after the divorce, when filing separate returns, both parties must satisfy the ownership test. If the title is in Bill and Jen’s names, each will separately meet the ownership test. However, if ownership is transferred to Jen in the divorce, or for some other reason Bill is removed from the title prior to the sale, he will fail the ownership test.
Thus, it’s always a good idea to make sure that each party is on the title in the agreed ownership percentages. Since IRC § 121(d)(3)(A) provides for the holding period of the transferor to be deemed that of the transferee in section 1041 transfers, the ownership percentage can be changed at the last minute of a divorce. If one party was never on the title, he or she can be added and be considered an owner for the entire time the former spouse was an owner. If Jen and Bill agree to a 50/50 division of proceeds and gain allocation, the title should reflect this ownership. If they agree to 70/30, the same applies—but keep an eye on the gain. Make sure one party’s allocation doesn’t exceed the amount of gain that he or she can exclude. A little planning goes a long way and in the end may make everyone a little happier. The rule of thumb is to remember that “tax follows title,” so if you own 30% of the house, you will be allocated 30% of the gain.
TRANSFERS INCIDENT TO DIVORCE: A LIMITED-TIME OPTION
Section 1041 deals with transfers between spouses, whether related to divorce or not. The section includes the rules for nontaxable transfers of property in divorce. For divorcing couples, the rules to keep in mind are (1) any transfer within one year after the date on which the marriage ceases is assumed to be “incident to divorce” and nontaxable; and (2) a transfer pursuant to a divorce or separation instrument (including modifications and amendments) can be made up to six years after the date the marriage ceases and still be considered nontaxable as incident to divorce. Transfers after these dates are presumed to be not related to the cessation of the marriage and therefore taxable (it is possible to rebut this presumption). These transfers have carryover basis, and transfers to third parties can qualify. Note that this section does not apply to nonresident alien spouses.
MORTGAGE INTEREST DEDUCTION
Once they agree that the home will be listed and sold as soon as possible, Bill may wonder how to deduct the interest on the mortgage payments he is making while not living in the home. Before the divorce is final, if they file a joint return, the mortgage interest and real estate taxes are deductible in the usual manner. The rules are different if they file separate returns.
With an agreement granting use of the property to Jen, IRC § 163(h)(4)(A)(i)(I) describes the term “qualified residence” to include the principal residence as defined in IRC § 121. Since section 121(d)(3)(B) provides that “an individual shall be treated as using property as such individual’s principal residence during any period of ownership while such individual’s spouse or former spouse is granted use of the property under a divorce or separation instrument,” the mortgage interest that he pays could be deducted on his separate return.
Again, note that just moving out won’t work—a divorce or separation agreement must be in place. Absent an agreement, the residence would not be Bill’s principal residence, and the interest generally would not be deductible. One exception would allow Bill to try to qualify for the mortgage interest deduction without an agreement. The Code and regulations do allow him to deduct the interest by electing to treat it as his second residence. Of course, he would have to not already be claiming a deduction for a second residence, and this generally would be allowed only in the year he moves out of theresidence, as he would need to use the home for more than 14 days in a year (or, if greater, 10% of the number of days it is rented at fair rental (IRC § 280A(d)(1)).
Also remember that when married taxpayers file separate tax returns, the mortgage limits are one-half of the joint- or single-filer limits; that is, interest is deductible on a loan up to $500,000 and home equity indebtedness up to $50,000.
Be careful allocating these deductions between parties in the year of the divorce. It can be difficult—especially in community property states. Planning can be a big help; advise the parties to agree before the end of the year who will deduct various expenses. This avoids “turf battles” at tax time.
HELP KEEP COMMUNICATION CHANNELS OPEN
It might be wishful thinking to have a divorcing couple communicate about such things, but this is a great opportunity for the CPA to help minimize stress for both parties (see sidebar, “CPA Services to Divorcing Couples,” below). Bill and Jen are ultimately the ones who must work out these issues while they continue to try to sell the residence. But as their CPA or financial adviser, you can help them plan to minimize taxes while coordinating information between them during a difficult time.
CPA SERVICES TO DIVORCING COUPLES
It is tempting for CPAs with a long-standing relationship with a couple to want to assist them with dissolution questions. Be very careful with this arrangement. Many advantageous actions for one party are equally disadvantageous to the other. You would certainly want each taxpayer to sign a separate engagement letter. As a practical matter, you might agree to have all meetings together, or at least to memo the highlights of any meeting and provide copies to both parties at the conclusion of each meeting. It is important to note that such engagements are rife with potential conflicts—and may lead to complaints to state boards.
Despite the current soft residential real estate market, many families could recognize a considerable gain upon sale of their home. When couples divorce, the disposition of the home is often complicated by conflicting priorities. The depressed market only adds to this complexity. As a result, a family home sometimes is more of a burden than an asset.
Rules governing maximum exclusion from taxable income of gain on the sale of a principal residence under IRC § 121 take on additional nuances in a divorce. Generally, single individuals may exclude up to $250,000 of gain and couples filing jointly up to $500,000, subject to several restrictions. Many of the nuances deal with opportunities and challenges of meeting the “two-out-of-five-years” ownership and use tests.
One option is a transfer incident to divorce under section 1041, which allows one party to transfer his or her interest to the other with no tax consequences, as long as neither spouse is a nonresident alien.
Another frequent consideration is the mortgage interest deduction. If a spouse or former spouse files a separate return and one, but not the other, is granted use of jointly owned property, the interest payor can deduct interest payments even if it is no longer his or her principal residence—but only if the arrangement is pursuant to a divorce or separation instrument.
David A. Stolz (email@example.com) is president of Stolz & Associates PS in Seattle and Tacoma, Wash.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at firstname.lastname@example.org or 919-402-4434.
- “Divorce Agreement Language,” JofA, Sept. 04, page 25
- “Tax Issues in Divorce,” The Tax Adviser, Sept. 01, page 610
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- A CPA’s Guide to Family Law Services—Forensic and Valuation Services Practice Aid 05-1 (#055299)
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