Proper Planning in Divorce for the Family Home
Written by: Cheryl Nielsen, Certified Divorce Financial Analyst™, Forensic Real Estate Divorce Strategist™
The family home is often times the biggest financial asset in a divorce and for that reason it deserves the utmost consideration and planning. Unfortunately, some will cling to the idea of keeping the family home wearing emotional blinders not realizing they are setting themselves up to fail financially not having all the facts. They may be unaware of the true costs of maintaining the home. Or, that the foundation is built on an underlying tax bomb in the form of capital gains upon sale. They in essence don’t know what they don’t know. Often, it is the spouse that didn’t handle the finances during the marriage or pay the bills that is unfamiliar with the total costs to financially carry the house. Perhaps too they never sold a home before and don’t understand how capital gains work or that proper planning utilizing the divorce tax rules could mitigate the tax ramifications upon sale.
I have found a lack of proper planning in many divorce cases that fail to address all the scenarios and ramifications to bring clarity to the decision making process. After the divorce is over, some get the “wake-up call” too late–when they file taxes the following year after selling the family home. Now a divorce settlement may have a big chunk of money missing after they cut Uncle Sam in for capital gains. Another spouse may have benefited from a gross equity equalization and spared the tax consequence.
If one spouse is unwilling to part with the family home and this creates an impasse in reaching a settlement agreement, due diligence is needed to bring a dose of reality to the table. One spouse’s concern over a clean break from the jointly held mortgage (if your spouse can not qualify for a new loan) is valid. Maybe the numbers don’t add up. Maybe the spouse that wants to keep the family home will drain his or her financial resources (divorce settlement) setting him or her up to fail in the not so distant future. Especially after alimony or child support ends. The instability in your spouse’s financial future that keeps the home has the potential to impact your financial stability. In the event he or she defaults on a jointly held mortgage, your credit reputation could be impacted not to mention placing you in a situation to stabilize the home financially if the mortgage becomes in arrears. If your agreement is to sell after the youngest child reaches 18, where is the real estate market projected to be? A declining market can erode equity and if your agreement guarantees one of the spouses a set dollar amount, it could end up an uneven division.
So how can clarity be gained over the housing circumstance to show the financial reality of decisions with the family home? Clarity comes through knowledge and this can be achieved through some essential real estate planning that explores all the options for the family home and the consequences of each option. A professional that could help with this is a 1) Certified Divorce Financial Analyst™ (CDFA™) & 2) Forensic Real Estate Divorce Strategist™.
Here are the basic considerations that need to be addressed:
Determine the total cost to maintain the home. This includes the mortgage(s) property taxes, insurance, home owner association dues, utilities, pool cleaning, housekeeping, maintenance, lawn care, etc. It’s easy to plan financially just on the mortgage payment, but the other costs associated with keeping the home can add up quickly and the total cost might be an eye opener. In all fairness, the mortgage interest and property taxes are tax deductible, so the net cost of these expenses can be allocated to the monthly expense.
Determine the current market value of the house. A Certified Real Estate Appraiser could make this determination and provide an appraisal or you could request a comparative market analysis from a local real estate professional which will give a snapshot of sales in your area and a general idea of values for similar properties. If you think you might have to litigate regarding the family home, opt for the appraisal and hire an appraiser that can also act as an expert expert witness in court if necessary.
Determine the Equity Value of the House. After the value of the house is determined (or a close estimate), deduct the liabilities from it such as the mortgage balance, property tax liens, judgment or mechanics liens. If you are unsure if there are any liens on the house, you or your professional can hire a title insurance company to run a title search, or you can visit the records office in the city or county where your deed is recorded and ask for assistance.
Determine the cost to sell the house. Consider agent commissions, closing fees, and fix-up costs to prepare the house for sale. If you are unsure of these fees, you could seek out a real estate professional for assistance.
Determine the tax basis for the house. Generally speaking, the tax basis is the original purchase price plus the cost of any improvements minus any tax benefits realized from deductions made perviously. This is an important number and should be calculated by your tax or CDFA™ professional. The basis is used to estimate the capital gains upon the future sale of the property. The IRS provides specific tax rules surrounding divorce. These rules are not necessary widely known even within the divorce community. It could prove advantages to know them, before reaching a settlement, to be in the position to benefit from them. You may also need to express your intentions clearly in your settlement agreement to demonstrate your qualifications. Before reaching an agreement with the family home, coordinate with your attorney or mediator and tax professional and/or CDFA™ to solidify the tax planning. One of the biggest areas these rules come into play is when planning the sale of the house. If you have moved out of the family home and the divorce drags on, you may not qualify anymore for the maximum exclusion of profit ($250,000 for individuals and $500,000 for married couples) because you do not meet one or both of the rules of owning and living in the property for two of the last five years. However, you may still qualify under tax rules that allow you to use the occupancy of your spouse to meet the occupancy requirement and therefore still qualify for the maximum exclusion if both parties are on title. If that doesn’t line up, you may fall under specific event “safe harbors” that provide for a reduced maximum exclusion as a result of divorce. This is why prior planning is essential. Unless you want to cut Uncle Sam into your divorce agreement, make decisions with the family home with favorable tax results. Know the divorce tax rules and structure them properly before drafting or finalizing your settlement agreement.
Determine if your spouse qualifies for a mortgage. It’s a good idea to know if the spouse contemplating keeping the family home would qualify for a new mortgage. The last thing you want to do is just request that your spouse re-finance the property in your agreement in the future allowing her to take title and later find out she does not qualify. It is important to know that there are mortgage professionals that are certified divorce lending professionals (CDLP®) that understand the unique circumstances surrounding divorce and are knowledgeable about specific mortgage products and guidelines that work well for divorcing spouses. If you simply apply at your bank, the guidelines may not be suited for your needs. This specialized lending professional could make the difference in finding the right program to fit your needs.
After the above considerations are addressed, and you know where you stand on each of them, you can begin to consider options for the family home.
Selling the house and splitting the proceeds. This is most likely the “cleanest” option to eliminate joint mortgages and capture the maximum exclusion on capital gains. This option will still take tax planning to capture the maximum exclusion–especially if you have not been living in the house for two of the past five years.
One Spouse keeps the house. With the above considerations addressed, it will be easy to determine what a 50/50 split of the equity value is in the home. Your spouse should now have a clear understanding of the total cost to maintain the home and the costs to sale and taxable event upon sale. If your spouse does not qualify for a new loan and you are willing to agree to your spouse keeping the house with the existing joint mortgage, have an end date in mind. At some point, your spouse will either need to obtain a new mortgage in his or her name only or sell the house. You can stipulate this in your divorce agreement. I recommend checking the status of the mortgage on a regular basis and make sure the property taxes are being paid.
You both agree to jointly own the house after divorce. A big consideration is how you hold title. Holding title as joint tenants is different than tenants in common. Understand these differences and choose accordingly. The person paying the mortgage is the person taking the tax write-off for the interest. The same holds true for property taxes. You may need an equalization plan on how this impacts each person’s share of the proceeds upon a future sale. Will the person paying the mortgage and property taxes be entitled to reimbursement? Also, will the person who gave up the use of the house be entitled to half of the rental value for reimbursement? This is something you can discuss and agree upon ahead of time and stipulate in your agreement.
As you can now see, the family home deserves the utmost consideration and planning and you owe it to yourself to do the right planning. With knowledge, the emotional blinders can be removed and the reality of decisions are crystal clear. Numbers can speak for themselves and aren’t biased or one-sided, they simply are what they are–neutral advocating for both parties. With the right professionals on your team, you can make decisions that are based on fact and not emotion. The right decision can save you, the wrong decision can break you. Wrong decisions can have financial ripples for many years after the divorce is final. Once good decisions are made, everyone can move on with a peace of mind. Remember a house is an investment, a home is where your heart is. You can make a home anywhere you live–so don’t hold on too tightly to the family home, sometimes letting go is the right answer.