Your primary residence in a divorce

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Joe,

My wife of seven years and I have been talking about divorce. While nothing is finalized yet, I am curious what we can do with our family home. Should we sell it now and split? Wait? Will the selling hurt us coming tax time?

Roland, White Bear Lake

Roland,         

First, let me say I am sorry to hear you are going through such a difficult time. Divorce is not easy—not emotionally and not financially. While I hope you don’t need this advice, it is good you are preparing now.

I am not sure of the exact particulars of the situation—for instance having kids, time lived in home, and current marital status all play a role in determining the best course of action. That said, here is a hypothetical example I give many of my clients:

Let’s say Jack and Jill, a couple who has been married for five years, decide to separate. In the past, in a housing market long, long ago, it would have been easy for the couple to sell the home and divide the profit. If they divorced and filed as “single”, Under IRC §121 Jack and Jill could exclude up to $250,000 of gain on the sale of a principal residence if the ownership and use tests are met. To meet these tests, both Jack and Jill would need to  1) own and  2) use the home as their primary residence for two of the five years preceding the sale. However, if one of the spouses did not meet the test, they might be best off staying married until  year end and file jointly.  This way Jack and Jill could claim $500,000 so long as they both meet the use test and one of the two meets the ownership test.

Additionally, reduced exclusions are available to those couples who fail the two out of five year test due to health, employment, or marital changes—think divorce or lay off.

However, the plummeting real estate market has turned many homes into toxic assets. Many couples cannot afford to sell their homes at their current value. In that situation, Jack and Jill may decide to have Jill continue to live in the house, and pay Jack his portion when she sells or refinances the house. However, this is problematic in a couple respects.

First, with the current real estate market, it may be a considerable time before the home is sold at a favorable price, leaving Jack waiting for his potential payout. Second, Jill would need to sell the house within three years of the divorce for Jack to be eligible for the exclusion.  This time frame can be extended to six years if the former spouse is granted use of the home by a divorce “instrument.”

Also, Roland, make sure you keep the lines of communication open with your former spouse. This will provide a chance to communicate a strategy that is most advantageous to both of you. Then make sure you find a tax professional to handle the situation should the divorce proceeding continue. Not only will they provide you the best strategy to minimize your taxes, they will also protect you so you don’t unwillingly underpay your taxes and be liable for penalties years from now. The rules governing divorce and deductions are complex and nuianced.  Also, it may sound ideal to use the family CPA—they  have done the family taxes for years afterall. However, in divorce proceedings it is best for each party to have his and her own accountants, as some of the decisions that could be advantageous to one client, might be disadvantageous to the other. You want to make sure your CPA goes to bat for you.

Hope this information helps. As always, contact me should you need further advice. Best of luck reaching an amicable solution.

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