DIVORCE AND THE MARITAL HOME IN NEW YORK STATE

By: Janice Page, CPA, MBA

The marital home is often the largest asset of the marriage and linked with many emotional issues.  All these emotional and financial issues must be considered before its distribution is finalized.  The financial points that need to be addressed are listed below and are organized in the following manner: The Sale of the Home: tax issues, equitable distribution issues to be considered and planning points; Mortgage Interest and Real Estate Taxes: tax issues and planning points.               

SELLING THE MARITAL HOME- tax issues

1-If husband and wife have lived in and owned their primary residence 2 out of 5 years from the date of the sale, then they may exclude the first $500,000 of gain from taxable income.  If they are already legally separated or divorced and filing as single or head of household, and title is one name, then the gain exclusion is $250,000.  The ability to use this provision is limited to once every 2 years, with certain exceptions.  If gain exceeds these limits, or the gain was earned in less than 1 year at the time of sale capital gains rules apply. 

2-If spouses have joint ownership of the marital home and one moves out giving exclusive possession to the other spouse, the departing spouse can take advantage of the tax benefits as mentioned above when the house is sold.  Also, if the house were transferred to the remaining spouse from the departing spouse, the remaining spouses holding period includes the period that the transferor-departing spouse owned the property. 

3-Where a husband and wife own and live in separate residences, each spouse is entitled to a separate exclusion limit of $250,000 on the sale of his or her residence. If both residences are sold in the same year and each spouse met the ownership and use test for his or her separate residence, two exclusions may be claimed (up to $250,000 each), either on a joint return or on separate returns. 

4a-If a home is transferred between 2 spouses within 1 year of divorcing, and it is incident to a divorce, no gain or loss is recognized. The transferor's basis for the transferred property is carried over to the transferee.  This nonrecognition treatment is not available to spouses or former spouses who are nonresident aliens. 

4b-If you received your home before July 19, 1984, in exchange for your marital right, your basis in the home is generally its fair market value at the time you received it. 

5-If a couple is forced to sell their principal residence before meeting the 2 out of 5 year ownership and use tests because of a change in their place of employment or health or "unforeseen circumstances", the exclusion is prorated. As of December 2002, the IRS issued temporary regulations that defined divorce or legal separation, among others, as “unforeseen circumstances.”  The IRS allocates the exclusion on a daily basis:  count the lesser of the number of days of use versus the number of days of ownership and divide the sum by 730 days (365 x 2).  For example, if a couple lived in the home 365 days and owned it 183 days the gain exclusion is $125,342(183/730 x $500,000). 

6-The 1997 Tax Act eliminated the prior rules for selling a home that related to deferring gain and the $125,000 gain exclusion for people over the age of 55 years.  However, due to these prior rules relating to the ability to defer gain on the sale of the primary residence prior to 1997, the basis of the home currently owned may be very low.  Look at forms 2119 filed with the IRS for all home sales prior to 1997.  Has gain been deferred?  Don't assume the basis of the home is the cost at which the current marital home was purchased.   

7-The sale of a marital home in a foreign country may be taxed by that country.  A credit may be available for the taxes that individual suffered in the foreign country. 

8-The sale of a US home owned by a non-resident living out of the US follows the rules of "FIRPTA".  The attorney for the buyer must ask the seller if he is a US resident and a declaration must be signed.  If not a resident, 10% of the sales price is held in escrow and remitted to the IRS.  To recover the monies, a tax return must be filed.  To avoid these withholdings, the seller would need to follow procedures that include filing with the IRS a calculation showing that he is not realizing a profit on the sale.  Planning is critical here since a non-resident or an individual becoming a non-resident is under no obligation to file a joint return with his spouse. 

If an American becomes an expatriate, by renouncing his American citizenship or a long-term resident leaves the United States, the Expatriation provisions apply.  They presume that the purpose of becoming an expatriate is tax avoidance unless it can be proven otherwise.  The expatriation provisions prevent the exclusion of gain on sale of residences. 

9a-The sale of a home also used for business purposes, has special considerations.  The taxpayer does not need to allocate gain between business and residential use if the business use occurred within the same dwelling unit as the residential use.  The taxpayer must pay tax on the gain equal to the total depreciation that was taken or was allowed after May 6, 1997, but may exclude any additional gain on the residence, up to the maximum amount. The tax rate on the depreciation taken is at 25%.  (NOTE: the new capital gains rates of 5% and 15% do not apply to the tax on the depreciation that was taken.) For example: The total gain on the sale is $100,000 and depreciation of $10,000 was taken in past years.  Only $90,000 of gain is excluded and $10,000 is taxable costing $2,500 in taxes. 

9b-If the business use property was separate from the dwelling unit e.g. unattached garage, the taxpayer would allocate the gain and be able to exclude only the gain on the residential unit. For example, if 75% of the home was non-business use, only 75% of the gain can be excluded from taxes up to limits as noted in item #1. The business portion of the game is reported on form 4797 and taxed at capital gains rates. 

10-“Basis” must be calculated in order to determine gain or loss.  If there is a gain, basis is the original cost of the property including the nondeductible costs for the lawyer, title insurance, mortgage recording fees, etc., plus cost of improvements, unamortized refinancing costs, less depreciation taken and reductions in value due to casualty losses. Basis for a loss, is the lesser of the above calculation or the market value when the property was converted to business use.

11-A loss on the sale of a personal residence is not deductible.  However, if part of the house was used for business in the year of sale, the loss related to the business use is deductible on form 4797.   

12-In case you need to show proof of your basis calcualtion to the IRS, you need to save all documents that support your calculation for at least 3 years from the date of sale.

SELLING THE MARITAL HOME- equitable distribution issues 

1-If the marital home was purchased from earnings while married, then it is subject to the rules of equitable distribution upon the dissolution of the marriage.   

2-Issues arise when the home was purchased either with separate property or with gifts from parents of one spouse. (Separate property is property that existed prior to the marriage, inheritance, gifts given directly to one spouse or personal injury awards).  For these items to maintain their character, they cannot be commingled with joint property or been subject to active appreciation by either spouse during the marriage. 

SELLING THE MARITAL HOME- planning 

1-If separate monies are used to buy the marital home, a prenuptial agreement should acknowledge that separateness so that upon divorce that spouse will receive those monies first upon the sale of the home. 

2-If parents of one spouse choose to gift the couple money towards the purchase of the marital home, the parents might consider "lending" the couple the money instead.  A true note must be signed with arms-length terms that include a stated interest rate that is at least that of the IRS' published rate.  However, the parent's must pick up the interest income on their tax return under IRC section 7520.  The children cannot pick up the expense as mortgage interest unless the loan is recorded and secured by the home.  In this case, if the non-child gets to keep the house, the parents would receive their loan back upon its sale.  (If the loan is more than $11,000, it cannot be interest-free.) 

3-When planning for the division of the marital property, all assets including the marital home and vacation home must be valued at their after-tax value, not pre-tax value.  For example, let's say that both the marital home and the vacation home each have the same market value of $300,000 and the same basis of $100,000, each having an unrealized gain of $200,000.  If the husband received the marital home upon divorce and the wife received the vacation home and each sold their asset after the divorce, the wife would have taxes to pay and the husband would not; he is benefiting from the gain exclusion which is only available to the primary residence not vacation home.  This was definitely not an equitable distribution of assets. 

4-A couple may jointly own property, such as a vacation home, that they both wish to retain after the divorce.  Upon divorce, joint ownership is automatically converted to a tenancy in common, which gives either spouse the legal right to sell his/her interest in the property and leave the other spouse with an unwanted co-owner.  To protect them from this, the divorce settlement should spell out how the property will be handled after the divorce.  Have it specify each spouse's right to use the property, and liability for related costs.  Also include a right of first refusal for each spouse should the other decide to sell, and a means of appraising the property to determine a fair price. 

5-Maintain complete files to support the basis calculation of the home in order to eliminate or reduce the gains tax.  Receipts for all improvements should be kept in a secure place along with the original closing documents. 

6-A sale of a principal residence does not have to be reported on a 1099-S form if the seller gives the real estate agent responsible for the closing, written assurance that the home was the seller's principal residence and that the full gain on the sale is excludable from income. 

7-If the taxpayers are currently living in a cooperative apartment, one must be sensitive to the whims of the coop board.  If the current apartment is too expensive for the remaining spouse to keep, the board may not allow her to buy into a smaller and less expensive apartment in the same building.  The non-moneyed spouse may also have difficulty buying into a different coop building. 

MORTGAGE INTEREST and REAL ESTATE TAXES- tax issues 

1-For mortgage interest to be deductible it must be "qualified residence interest".  "Qualified housing interest" is interest paid on housing debt secured by the taxpayer's principal residence and or second residence. (Sec. 163 (h)).  The debt is required to be secured by a perfected (recorded) security instrument.  "Qualified housing interest" is classified as "acquisition debt" or "home equity Loan." Acquisition debt is incurred for the purpose of acquiring, construction or substantially improving the residence. Home equity debt is any other loan secured by a "qualified residence", defined as a principal or second residence.    

2-Debt incurred incident to a divorce to purchase a primary residence from the other spouse or former spouse is acquisition debt for the deduction of interest on such debt, provided the total debt does not exceed the lesser of the fair market value of the property or $1 million ($500,000 for a taxpayer filing separately).  The mortgagee can be a third party such as a financial institution or a former spouse.   

3-Home equity interest is deductible to the extent that the loan does not exceed the lesser of the fair market value of the property reduced by the "acquisition debt" or $100,000 ($50,000 for a married taxpayer filing separately). 

4-Where the spouse cannot qualify the marital home as the taxpayer's principal residence, the interest paid on the debt secured by that house may qualify as residence interest on a second residence.  A second residence is any dwelling unit owned and personally used by the taxpayer as a residence.  Personal use includes use by a family member of the owner taxpayer.   

5-The issue of mortgage interest and real estate taxes and who gets the deductions for them is an issue fraught with confusion and often at risk without careful planning. Generally speaking, the ability to deduct the interest expense and taxes is based on who is legally liable for them, who pays them and who owns the property.  See tables on page 7 from the IRS' publication #504 Divorced or Separated Individuals.  Revenue Ruling 71-268 discusses the interest deduction in general and Revenue Ruling 72-79 discusses the deduction for taxes. The following are 2 additional scenarios to help determine who gets the deductions:

5a-A new husband moves into his wife's home; title and mortgage remain in her name.  Husband pays the mortgage with monies from his separate account.  They file separate returns.  No one gets the mortgage interest deduction because the husband is not legally liable to pay the mortgage and it was the husband who actually paid the mortgage, not the wife. Same goes for the taxes.

5b-Title is in both names but husband's name is on the mortgage.  Wife remains living in the home for a set amount of years.  Wife pays the mortgage.  Wife gets the mortgage interest deduction and real estate tax deduction.  Husband, however, is still responsible for the mortgage. 

6-Points from Refinancing: To assist in the property settlement, the spouse who remains in the marital home may refinance in order to pay off the departing spouse. Points on a refinance are deducted over the life of the loan, not all at once as with an acquisition loan.  However, if some of the refinanced monies are used to improve the home, then that proportionate amount will enable that same proportion of points to be deducted in full. If you are refinancing for a second time, you can deduct the remaining balance of points, from the first refinance, in full. 

7-Interest Expense from Refinancing: If you refinance more than the old loan balance on the marital home, the first $100,000 of the excess is treated as home-equity indebtedness.  Interest on that $100,000 is fully deductible regardless of how the money is used.  If more than $100,000 of home-equity interest is borrowed, the amount that exceeds $100,000 is not necessarily deductible.  If the excess is used for business or investment, the interest may be deductible, provided you can prove how the money was used; if the excess is used to payoff the former spouse, the interest in not deductible.  If treated as investment interest, certain limitations apply. 

8-An Alternative Minimum Tax (AMT) adjustment is required to be made if the interest was incurred for any purpose other than to buy, build or substantially improve the principal or second residence. 

MORTGAGE INTEREST and REAL ESTATE TAXES- planning 

1-Try to include in the divorce agreement that the spouse who remains in the marital home will refinance the old mortgage in order to relinquish the departing spouse from liability.  This may not be possible if the remaining spouse has little income and/or a poor credit rating.  The cost of the refinancing should be considered in the division of the marital assets. 

2-The decision to file a joint return versus  married filing separately, while going through the process of divorce, can hinge on the issue of the real estate tax and mortgage interest deduction. For this example, a separated couple in the 42% tax bracket (35% federal plus NYS & NYC's effective rates) has a $200,000 mortgage at 7%, with $6,000 a year in real estate taxes, for a total deduction of $20,000.  The husband has been paying his wife $5,000 each month in temporary alimony.  If they file jointly, they get to take the $20,000 deduction for a tax savings of $8400.  But, if they file separately, the husband gets to take a $60,000 deduction for alimony resulting in a tax savings of $25,200.  If the wife then reports her $60,000 income and then she takes the $20,000 for mortgage interest and tax deduction, her tax cost is approximately $11,000.  By filing separately they save $14,200 in taxes ($25,200-11,000). In this case it is better to file separately for a net tax savings of $5,800 ($14,200-8400). 

3-It may be more beneficial for a taxpayer who has left the marital home to have the mortgage he pays qualify as alimony rather than as mortgage interest.  Alimony includes payments paid to a third party, such as a mortgage, for the benefit of the payee spouse, providing that this transaction is written into the divorce agreement.  The deductibility of mortgage payments is limited to the interest expense not the principal; whereas, if the alimony payment is to pay the mortgage then the entire mortgage payment can qualify as alimony and be fully deducted.  (See example #2 above). 

4-An alimony deduction could be lost if the departed spouse is ordered to pay the mortgage payment of the former spouse and this obligation does not end on the death of the former spouse.  

5-If a divorcing couple has a home equity line of credit, with available credit, they are in financial danger.  Home equity lines of credit can be accessed by check as well as by credit card by either party; and, the non-borrowing party can be held responsible for paying it back.  If too much is borrowed and cannot be paid back, the house may be lost.  Close attention must be paid to this account.  One should consider canceling the line or having the borrowing privileges stopped.  Send a certified letter to the financial institution to make this request. 

6-Refinancing a coop may not be allowed by the coop board or may have severe restrictions.  This potential problem must be taken into consideration when the final property distribution is made.