Dan Reiter, CFP®, CPA
The marital home is often one of the most valuable assets that couples must divide during a divorce. As such, it’s crucial to plan carefully when negotiating its ownership or sale.
Plan for Affordability
Before deciding to keep the marital home, it’s essential to evaluate its long-term affordability. Consider the ongoing costs of maintaining the property, including mortgage payments, property taxes, insurance, utilities, and repairs. Your financial situation has likely changed due to the divorce, so it’s important to determine if you can realistically afford to maintain the home. If you’re unsure, it may be wise to reconsider keeping it, as doing so could lead to significant financial strain.
A financial planning professional that specializes in divorce planning can help you make such a determination. Before you decide whether to negotiate for the marital home, it’s important you understand how such a decision fits in with your financial situation post-divorce. For example, it is critical to understand the answers to the following questions:
I. What will be your post-divorce income sources?
II. What will your other living expenses and post-divorce budget look like in detail?
III. What other debt obligations do you expect to have?
IV. What is the cost of alternative housing options?
Choosing whether to continue to own the marital home is fraught with a lot of emotions. However, it is important to consider your situation objectively by understanding how answers to such questions above fit into the “big picture” of your long-term financial situation.
Plan for Taxes
Tax implications are another important factor to consider when deciding what to do with the marital home. This is an area where it is also easy for tax mistakes to occur, which can result in sizeable dollar losses.
First, ensure you have adequate records to document the purchase price of the home and cost of any substantial improvements. This information will help determine your "cost basis." Generally, you'll owe capital gains tax on the difference between the sale price (less selling fees) and your cost basis. If you do not have adequate records to support what you paid or what dollars you put into the marital home, you may not be able to claim those dollars to help reduce your gain on the property sale.
There is also a special exclusion from tax gains available for principal residences. This exclusion allows you to exclude up to $250,000 (or $500,000 for married couples filing jointly) of taxable gain from the sale of your primary residence.
To qualify for the exclusion, you must have owned and lived in the home for at least two of the five years preceding the sale. There are also special rules for ex-spouses who have moved out of the marital home. If your ex-spouse is granted use of the property under a divorce or separation agreement, the spouse that moved out may qualify for the “use test” for the entire period the ex-spouse lived in the home.
The rules for the exclusion can be complex. To illustrate, let’s consider two examples:
Example I: Bob and Sue Smith have just finalized their separation agreement and divorce in August of 2024. Sue plans to continue to reside in the family home for a few more years until their youngest, Brian, heads off to college. Their home is worth $1 million, substantially more than the $400,000 they paid twenty-five years ago. There is no mortgage debt on the property.
Their divorce agreement stipulates that they will retain joint ownership of 50% each in the home and will split any proceeds according to their ownership percentages when the home is sold. However, Sue is given the right to live in the home until Brian is expected to go to college. Sue and Bob sell the home four years later for $1 million.
Result: Sue and Bob each realize a gain of $300,000 (one-half of the $1 million sale price less one-half of their respective cost of the property). However, both meet the requirements to exclude $250,000 of such gain from tax. As a result, each report a taxable gain of $50,000 as part of their income. Assuming a tax rate of 20%, they would each individually pay $10,000 in tax, and $20,000 total.
Example II: The same facts apply as in Example I. However, in this case, Sue negotiated to keep full ownership of the family home as part of the divorce agreement, and as a result, gave up $500,000 in other after-tax assets. She holds the home four more years, and then sells for $1 million.
Result: Sue realizes a gain of $600,000. As an individual, she can only exclude up to $250,000 of the gain from tax. As a result, she has a taxable gain to her of $350,000. Assuming a tax rate of 20%, she owes tax of $70,000 on the sale. Bob’s exclusion cannot be used as he no longer owns the property, and they no longer file a joint return.
The resulting tax cost was $50,000 more than what would have occurred with a more carefully constructed plan.
Conclusion
In this article we discussed how failing to consider long-term affordability of your marital home as part of your divorce can add considerable risk to your financial future. Moreover, ignoring tax implications on the future sale of the marital home as part of your divorce negotiations can result in significant dollar losses to taxes. To avoid such issues, consider meeting with a financial professional well versed in both taxes and divorce planning. The cost of such planning may very well be a fraction of making costly errors.
To schedule a complimentary 30 minute meeting to discuss your situation, you may click here or call our office at (816) 587-7526.
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