When couples mediate they have lots of options to consider when addressing what will happen with the family home. If the issue is litigated the options are usually for one spouse to buy out the other one through a refinance or that the house be sold. Sometimes these two options do not make the most sense for the family and through mediation couples can get creative on terms that best meet their needs. In a previous blog I discussed how the substantial rise in interest rates has given couples a large financial incentive to delay refinancing to continue enjoying the lower existing rates. Couples are considering solutions that might split the benefit of not requiring a refinance through continuing to jointly own the property, or by way of the benefitted spouse compensating the other spouse in some fashion for not requiring the refinance to the higher rate. As couples creatively approach the house issue another possibly significant consideration is the issue of capital gains that will arise when the residence is sold. Today’s blog addresses some basic capital gains considerations each divorcing couple should understand when making decisions about what to do with their home.
The Basics When you sell your home any profit on the sale, measured by any increase in value from the date it was purchased to the date it gets sold, is considered a capital gain and may be subject to being taxed. There is an exemption if certain requirements are met that allow a single person to exempt $250,000 of the gains and a married couple to exempt $500,000 of the gains. The requirements to qualify for such exemption are as follows:
-The Home being sold is your primary residence.
-You’ve owned the home for at least two years in the five year period before selling it.
-You’ve lived in the home for at least two years within the five-year period before selling it. The years you’ve lived in it don’t need to be consecutive.
-You didn’t acquire the home through a like-kind exchange (also known as a section 1031 exchange) within the last five years.
–You haven’t claimed the exclusion on another home in the last two years.
Typical Capital Gains Treatment with Sale of home at Time of Divorce. When couples decide to sell the family residence at the time of the divorce the Capital Gains issue is pretty straightforward. Typically, the couple would have been living together in the residence for at least two of the preceding five years and the house would typically be held jointly by them at time of sale. In this situation they would be able to write $500,000 in gains. As an example, if they bought the home together for $700,000 and then sold it at divorce for $1,200,000, there would not be a capital gains issue because the $500,000 in gains would be within the exemption allowed. If the value of the house had gone up even more than any additional gains would be subject to capital gains taxes.
What About When One Spouse Buys Out the Other? Let’s take the same house values as reflected above, but now, instead of the house being sold, one spouse buys out the other’s interest in the home. The spouse proceeding with the buyout would pay the other spouse one-half of the equity after considering any mortgage amount owing. This event does not trigger any capital gains issue since the house is not being sold. The issue would arise at some point in the future in the event the spouse with the house decides to sell it. At that time the owner spouse will run into a capital gains issue even if the house value does not change. That one spouse would now be selling a house with $500,000 in capital gains from the date of purchase to the date of sale, but rather than having a $500,000 exemption ($250,000 for each spouse), the owner spouse will now only have a $250,000 exemption because the exemption for one spouse is $250,000. A party moving forward with a buyout needs to recognize this possible eventuality that will arise in the event the house is sold.
What About Continuing to Jointly Own the House. In mediation couples often also consider remaining joint owners of the family home. They might agree to have one spouse remain in the home and pay the mortgage while the other spouse’s equity remains in the home and title is held jointly until either spouse elects to dispose of the asset. This arrangement may navigate around the capital gains issue that arises from one spouse coming off title. In this scenario timing can be everything. As mentioned above, to be entitled to the exemption, one of the requirements is that the party needs to have spent two of the previous five years on both title and in occupying the home. If one of the spouses has moved out, the capital gains exemption begins reducing once the out spouse has been out of the residence for any period over three years. If the house is jointly owned, but one spouse has been out for five years before the house is sold, that one spouse would not be able to assert their $250,000 exemption against the $500,000 in capital gains so there would be a capital gains tax issue on $250,000.
Some Solutions Given the Capital Gains Issue. Some solutions I have seen regarding the capital gains issue include the following. One option is that either one spouse remain in the home, or both move out and a renter is brought in and the couple remain as joint owners for a maximum of three years and at that time they sell the home which allows for the parties to claim the maximum exemption. Another option is the couple continues to jointly reside in the residence and they continue to do so until either decides that they want to dispose of the house and it can be sold at that time. With this option the parties both remain in the home so there is no issue of time running impacting the two year “living in the home” requirement. When one spouse elects to buy out the other spouse it is really important that the spouse retaining the property understand that there may very well be capital gains tax issue in the event they decide to sell. Sometimes a spouse may wish to stay in the home until a child graduates from high school. If that is only a couple of years away and the plan is to sell once the child graduates, it may be a lot more practical to continue jointly owning the property so that the maximum exemption is available upon sale to maximize the net return on the sale and avoid as much taxes as possible. If both spouses support this arrangement it is easy to accomplish. If one spouse wants their equity in the meanwhile there are creative ways to get them their equity but to also keep them on title to preserve the eligibility for a maximum capital gains write off.
When couples explore their options regarding the family home, it is important to understand the tax implications in doing so. It may be desirable to hold onto the home, but in doing so it is really valuable to understand how that decision might impact how much equity is realized when the home is finally sold. Be sure to get sound tax input from a trusted CPA as you move forward with making such important decisions.