When couples own a primary residence and rental properties one idea for asset division is for one spouse to stay in the primary residence and for the other to move to one of the couples’ rental homes. While this is convenient, the tax costs should be considered when valuing the properties.
Section 121 IRS rules allow a $250,000 capital gain exclusion for singles and $500,000 for married couples upon sale of the primary residence. Capital gain is the sales price less selling costs (mainly realtor costs) less the adjusted purchase price (adjusted for improvements to the home but not maintenance or repairs). Financing, such as mortgages or home equity loans, does not factor into the calculation. Section 121 exclusions require that the spouses live in the home for 2 out of the last five years (not the last two years) and own the home for at least two years. Section 121 can be used once every two years. After divorce, the time in a co-owned home used by the ex-spouse may count for both spouses. Each spouse would get a $250,000 exclusion of capital gain upon eventual sale. If the home is awarded to one spouse, that spouse may only get a $250,000 exclusion upon sale. This is an important issue to address if at the time of divorce the home has a capital gain of greater than $250,000 since estimated after tax proceeds upon sale may be less than a client expects due to taxes.
But what happens to a spouse that is awarded a rental property owned and rented by the couple during the marriage. If s/he lives in the rental property for two years post-divorce, will s/he get a $250,000 capital gain exclusion upon sale? Yes and no. More importantly, this fact impacts the after-tax value of the rental property awarded. First, any depreciation on the rental property taken previously will be recaptured and taxed at a 25% rate. Second the capital gains exclusion under section 121 is available only for periods when the property was used as a primary residence. Any time since 1/1/2009 that the property was not used as a primary residence is non-qualifying use not eligible for the exclusion.
For example, Paul and Patty divorce. Paul is awarded the primary home and Patty is awarded their rental property. Patty decides to move into the rental home. Assume that Patty’s property was rented from 2011 to 2014 (four years) and she moved in at the beginning of 2015. It’s now 2017 and Patty plans to sell it at a price that will yield a $150,000 capital gain. Since there are only 2 years out of 6 that qualify for the exclusion, only 1/3rd of the capital gain qualified for the exclusion – which leaves 2/3rd ($100,000) that is taxed a capital gains rate PLUS taxes associated with depreciation recapture.
To make matters more complicated, depreciation recapture goes back to 1997. While you may get favorable capital gains treatment for 2000-2008 (since only non-qualifying use since 1/1/2009 counts) you will have an unfavorable depreciation recapture. Thus if the home was rented since January 1, 2000 until the end of 2014 (15 years), the non-qualifying use would be from 2009 to 2014 (6 years). Patty lived there for 2 years and it was rented for 9 years before January 1 2009. That’s 11 qualifying years (9 years from 1/1/2000 to 12/31/2008, plus 2 years of primary residency). A property owned before 1/1/2009 may result in more exclusions than on owned after 2009 – all of which must be considered when valuing the rental property. And all of which requires estimates by a qualified tax professional.
And of course, these rules could change under any new tax reform.
Don’t let this be a surprise to you or your clients. Pam Friedman of Divorce Planning of Austin has resources to help navigate challenges like these. Call us for a complimentary consultation by phone at 512 774 5340.
Pam Friedman, CFP®, CDFA™ is the Founder of Divorce Planning of Austin and a Partner at Silicon Hills Wealth Management. She is the author of I Now Pronounce You Financially Fit: How to Protect Your Money in Marriage and Divorce, published by River Grove Books and available on Amazon.com.
Investment advisory services offered through Silicon Hills Wealth Management, LLC, a registered investment advisor.
Neither Silicon Hills Wealth Management nor Divorce Planning of Austin do not provide legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.