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Keeping the Family Home in a Divorce Settlement: Ask Yourself Three Questions
Published Date : August 24, 2015
Many of the decision points during the divorce process require an equal blend of emotional, legal and financial consideration. One decision in particular often has a strong emotional overlay and a huge impact on life following divorce: whether or not to retain the family home. Often one of the largest community assets, a family’s primary residence also may feel like the physical embodiment of the family, so it is no wonder that many couples work hard to retain it as part of the property settlement. While many would agree that keeping the home is desirable, especially considering the well-being of the children, it is also important to think through the potential financial risks that retaining the home might pose for the divorcing parents. In order to help make an informed decision, you must ask yourself three questions:
1. What am I accepting when I agree to keep the home?
2. What are the tax implications, both positive and negative, of retaining the home, and how are they likely to impact me in the future?
3. Can I afford the home over the long term without depleting my other assets?
When the home is accepted by one spouse in the community property settlement, he or she needs to be informed and comfortable with exactly what they are getting. For other personal property assets that have material value, such as a privately owned business or artwork, most people hire a professional appraiser. Because of the familiarity of a home, neighborhood, and the general real estate market, a spouse may be tempted to agree on a value based on an educated guess; in reality, the process should be handled no differently than buying a new home. It is in both parties’ best interests to have the house professionally appraised to establish its current market value, and have a home inspection to ensure any value-impacting issues are taken into account. More than one appraisal may be appropriate if the first reveals a value that seems unrealistically high or low to one or the other party. If the home has a mortgage in place, a financial professional can help you understand the terms and potential risks of the existing mortgage. For example, the loan would typically need to be refinanced in order to retitle it in the name of one spouse. It is essential to understand the financial impacts of the refinance relative to the existing loan’s outstanding balance, monthly payment and interest rate. Spending the time, energy and money to have professionals appraise the property, inspect the home closely, and assess the mortgage will assure that the risks and costs of keeping the home are understood.
There are also some tax fundamentals to consider. For many homeowners whose properties have significantly appreciated over the years, the potential tax impact resulting from the sale of long-held property can be significant. So understanding whether there is an undue burden to a spouse retaining a home, as compared to undertaking an outright sale by the couple, is important. Three important elements need to be understood: what is the cost basis or the property (purchase price paid plus capital improvements, less gains on previously owned residences rolled into the current property); how will tax be calculated when the house is sold; and who will bear the tax cost when an eventual sale takes place? The first issue, cost basis, needs to be calculated by digging through files and tax filings. The tax will be calculated by first subtracting the cost basis from the sale price, less the expenses relating directly to the sale (for example commissions). Then, through IRS code section 121, individual owners are permitted to reduce their gain by $250,000, or $500,000 for a couple selling together (subject to criteria that must be met in order to qualify for the exemption*). If one spouse retains the home, he or she loses the advantage of their spouse’s $250,000 gains exclusion. As to who bears the tax, if the couple sells together do they share the tax burden, which is generally paid from proceeds? If one party takes the house, he or she will bear all the tax cost when a sale takes place. As an example, if a home purchased during the marriage for $500,000 is sold by its joint owners at its current market value of $2,000,000 during or shortly after the divorce is finalized, each spouse is entitled to use their $250K exclusion and receives their after-tax share of the proceeds. However, if one spouse retains the home for several more years and then sells, both the gain at the time of the divorce and any additional gain achieved over that period will be taxed to the owner, subject only to his or her $250K exclusion. If the house sells for $2,500,000, the seller is taxed on a gain of $2,000,000 less the $250K exclusion, or $1.75 million.** California taxpayers are currently subject to both the federal capital gains tax rate of up to 20%, plus a state tax rate of up to 13.3% or more. Admittedly, this is an over-simplification so it is imperative that a spouse retaining a long-held home get specific tax advice from a CPA to clarify their exposure.
Having covered the fundamentals, the most important consideration in deciding to keep the family home is whether or not you can comfortably afford to keep it without eroding other assets. When placing the value of the home in your column on the division of community property, you are trading it for other assets such as cash, securities, income-producing property, or a family business. There is a definite appeal to retaining the home, but it is also important to assure that there are real and secure income sources in place to supporting your lifestyle. In basic terms, is the house too expensive to retain? Should you consider a smaller home, scaled to your new life? It is important to test and understand early in the settlement process whether the remaining liquid assets, combined with other income sources, can sustain your lifestyle, including housing costs. If in reality you expect to gradually deplete your investment assets in order to retain the family home, it is extremely important to consider the risk you face as a consequence of that plan. If your lifestyle is nicely in balance, then you have the freedom to decide whether or not to stay in your current home. If on the other hand, you are likely to spend down your liquid assets, you become increasingly vulnerable to the ups and downs of the stock, bond and real estate markets because ultimately you may need to sell at inopportune moments to support your living expenses. Any market downturn can place you in a difficult position, and may actually trigger the need to sell your home. You can control this exposure by asking your advisor to test whether you can comfortably support your lifestyle given your desire to retain the house. If the intent is to hold the house for a relatively short period of time, your home is likely to have tracked the price movement of other properties, though you will likely bear a far larger portion of the tax bill than would otherwise have been the case.
Our homes are often fundamental to our family’s sense of security. It is important to consider all the options – including your ability to comfortably support the home – when addressing whether to sell or retain this very personal property. Your best approach is to rely on your advisor to help you assess the choices that will enable you to make an informed decision.
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