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 (the price adjusted up 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? 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 may only available only for periods when the property was used as a primary residence. Up until the new tax laws (2017), any time since 1/1/2009 that the property was not used as a primary residence was non-qualifying use not eligible for the exclusion.
Here was the old rule. 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.
And of course, these rules changed for 2018 and may change again!
Don’t let financial changes 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 Managing Director and Principal at Robertson Stephens Wealth Management, LLC.
Investment advisory services offered through Robertson Stephens Wealth Management, LLC (“Robertson Stephens”), an SEC-registered investment advisor. This material is for general informational purposes only and is not tailored to the needs of any specific individual. Any discussion of U.S. tax matters should not be construed as tax-related advice. Please consult your personal tax advisor for more information. © 2020 Robertson Stephens Wealth Management, LLC. All rights reserved. Robertson Stephens is a registered trademark of Robertson Stephens Wealth Management, LLC in the United States and elsewhere.