Going through a divorce? You've probably experienced some decision fatigue. 😣 You may feel some analysis paralysis and like you can't move forward on anything.
Worse, you may be so ready to be done with the whole thing that you're ready to sign anything, just to get it over with. There's so much to think about, and the stakes are about as high as your emotions.
Hang in there though- there are some seemingly small decisions that could cost you thousands, even tens of thousands of dollars in taxes. Let me explain...
The good news is I'm only going to focus on one thing here (the sale or transfer of your home), and I'm going to lay it out super simple. Here are the things you need to keep in mind when selling or transferring your home as part of a divorce settlement:
- If you plan to sell your home, and your capital gains are over $250,000, it may be advantageous to sell BEFORE you finalize your divorce. Why? Well, as soon as your divorce is finalized, you can no longer file your taxes as "Married Filing Jointly". If you file MFJ, you are eligible to exclude up to $500,000 of the capital gains for tax purposes. (Assuming at least one of you lived in the home for at least two of the most recent five years). Learn more here. If you file for divorce, then sell the next year, you're only eligible for the individual exemption of up to $250,000. This mistake could cost you tens of thousands of dollars in capital gains taxes!!! 😬
- If you're planning on one of you keeping the home and you currently have a balance on your mortgage, the only way to get the former partner off of the loan is to refinance at current interest rates. If you miss this, (sometimes even attorneys aren't aware!!!) you may come to an agreement on splitting property that doesn't consider the affordability of the new loan term, or the eligibility for one of you to qualify for the loan. Please consult a lender if your divorce settlement may involve refinancing any debt, so you can make an informed decision.
- Some couples choose to just keep the title and loan as is due to point #2, or other reasons, but remember this: If the loan is in both your names, so is the liability. If the partner who keeps the home misses a payment, that hits the credit report for the other person. If the partner who doesn't keep the home wants to buy one, or qualify for any other loans, their shared mortgage will show up on their debt-to-income ratio, potentially impacting their ability to qualify for a new loan.
Sidenote: Be extremely cautious of any proposed arrangements that involve removing you from the title of a property, but not the associated loan. This could come back to bite you.
- Some couples may keep the title and loan as is, with plans to change the title or refinance later. You'll want to be mindful of the six year window. You'll see in the tax code Section 1041(a) that the IRS allows spouses (or former spouses) to avoid capital gains taxes on property transferred during the settlement, or when the transfer is considered incident to the divorce. A property transfer is considered incident to divorce if the transfer occurs within six years after the divorce. If you miss this window, you will likely owe capital gains tax on the gains portion of the property value which was transferred.
For example- say you bought a home together early in your marriage for $200,000. Let's say you get divorced this year, but leave both names on the title. Fast forward 6+ years, and you need to get the former partner off the title. Let's say the home is now worth $600,000, having gained $400,000 in value since you bought it. When the ownership is transferred to you, half of that gain ($200,000) will be subject to capital gains tax. If you're at the 15% rate, that'll trigger a $30,000 capital gain tax bill.
- One way to avoid a capital gains tax on the sale of a property is to do a like-kind exchange. Also referred to as a 1031, the most important thing to note is that this refers to investment properties, not residential. There are many rules. IF you're wanting to take advantage of this tax code, and are willing to do the research and the work, here's the strategy in a nutshell:
First, the property being sold needs to be used as an investment property for one to two years prior to the exchange. If it's currently a residential property, you'd need to rent it for one to two years. Second, the proceeds from that sale need to be QUICKLY reinvested (Not going into details here, just note the rules are strict, work with a pro) in a similar property. If you want the full tax benefit, you'll want to reinvest the same amount or more than the gain from the previous property. Third, the new property you're buying then needs to be held for one to two years as an investment property. These steps add up to a qualified 1031 exchange. (If your intent was to purchase a residence, this would be the point you could move in.) I cannot stress enough that 1031 exchanges have extremely strict criteria, please consult a professional if you choose this route.
- I have seen so many people (usually women) just walk away from the home. Usually because they're emotionally spent, sometimes they have some feelings of guilt related to the ending of their marriage, and some just feel bad about asking for their fair share. Regardless of the reason, this is usually unfavorable for the spouse who walks away from the property. Consider the shared equity you have in the home. (Equity is the current resale value of the property less what you owe)
If you want a ballpark, you can look up the home value on a site like Zillow or Redfin. Subtract your current mortgage balance(s) to get the equity. If you're in a community property state and bought the home together, you're likely eligible to receive around half that equity. E.g. If your home is worth $500,000 and your current mortgage balance is $300,000, you have $200,000 of shared equity. Ask yourself: can you afford to walk away from $100,000? How will you make that up?
- I've also seen people make the mistake of keeping a home they can't afford. Now I promised to focus on the house in this post, so I won't go into how much retirement income people miss out on when they keep the house instead of retirement accounts. But this is one of the biggest mistakes you can make in divorce, as far as long-term impact. Ask yourself: how will your lifestyle be impacted if you keep this house? How much of your income, potentially including temporary spousal or child support, will go to housing versus the rest of your expenses?
- Keep in mind that with both the family home and retirement accounts, they may look good on paper but pose obstacles if you need to access funds, especially if you're not retirement age (59 1/2). Consider:
-If you want money out of the home, one option would be a line of credit or a cash out refinance, both of which you'd need to qualify for. Alternatively you could rent out a room (which you may or may not be comfortable with), or renting out the whole house (in which case you'd need another place to live).
-If you want money out of a qualified retirement account like a Traditional IRA or 401(k), those withdrawals will be subject to tax, and if you're under 59 1/2, also subject to a 10% early withdrawal penalty (with a few exceptions to the penalty)
-If you want money out of a Roth IRA or Roth 401k, you can withdraw CONTRIBUTIONS tax and penalty free. Any withdrawals of growth and earnings will be subject to tax and penalty.
I hope this information is helpful, and not too overwhelming. If you'd like help understanding how these decisions impact your holistic financial picture, now may be a great time to connect with your financial advisor. If you don't already have one, you're welcome to connect with me to see if we're a good fit to work together.
Have you learned anything in this post? Know something I missed that I should include? Please shoot me a message, I'd love to have this post be as helpful as possible. 🥰
On every single one of these points, please keep in mind there are exceptions, so please consult a professional for your unique situation!This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.