Hanging onto what's yours: how to weather a divorce and still keep your home.

Most married couples purchasing a principal residence choose to title their residence in joint tenancy (joint tenants with right of survivorship or tenants by the entirety). As such, each spouse has a 50% interest in the property. Should they sell their residence and purchase a more expensive principal residence, Internal Revenue Code Section 1034 (hereafter referred to as Code Section 1034) permits each spouse to rollover his or her portion of the realized gain.

A divorcing couple may unfortunately face several financial and tax-related problems with respect to their jointly owned residence. Among these problems are the retitling of the jointly owned property and the rollover of gain provisions of Code Section 1034. In this article, we shall examine the consequences of divorce with respect to the retitling of property and to the rollover provisions.

Transfer of Title Related to Divorce

To understand the consequences of transferring title prior to divorce, we must examine pre- and post-July 18, 1984, transfers of property related to a divorce settlement. Before the passage of the Deficit Reduction Act of 1984, any transfer of property made before July 18, 1984, created a taxable event. In particular, if a spouse transferred property to the other spouse, the appreciated value above his or her adjusted basis was a recognized capital gain to the transferrer spouse.

Example: Howard and Sarah bought a home in 1970 at an adjusted cost of $30,000, titling it as 50/50 owners (each had a cost basis of $15,000). In 1982, they file for divorce with the value of their home at $100,000. As part of the divorce settlement, Howard agrees to transfer his portion of their residence to Sarah. This transfer creates a taxable event to Howard in the amount of a $35,000 recognized capital gain ($50,000 less $15,000). With the passage of the Deficit Reduction Act of 1984, any transfer of property (after July 18, 1984) between spouses or former spouses "related to" or "incident to" a divorce is considered a "gift" with no recognized gain (or loss) to either spouse. In that regard, the donee spouse will inherit the donor spouse's cost basis of the transferred asset. The only prerequisite is that the transfer must be related to a divorce settlement. The specifics of "related to divorce" or "incident to a divorce" will be explained in more detail below.

The significance in the change of tax treatment behind the pre- and post-July 18, 1984, asset transfers is important. The reasoning behind the change was that the spouse who remained in the house would be eligible to utilize the Code Section 1034 rollover (and ultimately the Code Section 121 $125,000 capital gain exclusion, if eligible) should the residence be sold in the future. On the other hand, the transferrer spouse could purchase a new residence without restriction (related to the provisions of Code Section 1034). In particular, there would be neither a minimum purchase price (exceeding his or her cost basis in the old residence or transfer price to the other spouse) requirement nor a time restriction (two years before or after the transfer to the other spouse) in acquiring a new principal residence. Most important, in accordance with Code Section 1041, there would be no tax consequences to either the transferrer or to the transferee spouse when title to the property is changed to the name of the transferee spouse.

Defining "Incident to Divorce" and Related Problems

It is important to define and explain the concept of "incident to a divorce" or "related to the cessation of the marriage." IRC Section 1041(c) defines a transfer of property "incident to the divorce" if the transfer occurs within one year after the date on which the marriage ceases, or if it is related to the cessation of the marriage. Similarly, a transfer of property "related to the cessation of the marriage," as defined in Code Section 71(b)(2), occurs no more than six years after the date on which the marriage ceases. There is a rebuttable presumption that any transfer not pursuant to a divorce or separation instrument, and any transfer occurring more than six years after the cessation of the marriage, is not related to the cessation of the marriage. State law may supersede any federal law in regard to defining "incident to divorce" or "related to the cessation of the marriage."

With respect to the concept of "related to the cessation of the marriage," it is interesting to note what could happen should the divorcing couple agree to sell their house in the future and divide the sale proceeds between them at that time. This arrangement could unfortunately cause tax-related problems to the departing spouse.

Example: Peter and Michelle divorce, with Michelle staying in the family home purchased 15 years ago at an adjusted cost of $75,000. As part of the divorce settlement, it is agreed that Michelle will remain in the family home in order to raise their three daughters, ages 13, 10 and 8.

In 10 years, when the youngest daughter turns 18, it is agreed that the family home will be sold with Peter and Michelle splitting the sale proceeds. Peter moves out but his name remains on the property deed. He also helps Michelle with monthly mortgage payments.

Peter's potential problem is that at the time the home is sold, he would not have resided in the home and therefore cannot consider it as his principal residence. Any recognized gain on Peter's part is therefore not eligible for rollover in accordance with Code Section 1034. Furthermore, in accordance with Code Section 1041, there is no "transfer" of property related to a divorce because any transfer (of sale proceeds) would have occurred more than six years following the cessation of the marriage.

Peter could possibly be considered an "owner investor" of the family home. In this sense, Peter, through his monthly mortgage payments, would retain his investment of a "rental" property. However, the fact that Michelle has not paid rent to Peter for his "portion" of the residence could negate this arrangement. Under this "owner-investor" arrangement, Peter could possibly use a "like-kind" exchange to avoid tax on his portion of the recognized gain. Michelle, on the other hand, would be eligible to rollover her portion of the recognized gain if she purchased another principal residence.

With proper planning, Peter's problems could be avoided. In particular, if Michelle would have paid Peter for his equity in the house at the time of divorce, neither Michelle nor Peter would have realized any capital gains.(1) However, should the house appreciate in value, Peter would not have been able to share in the appreciating equity.

Sale of Residence Prior to Divorce Code Section 1034 permits a taxpayer (two years before or after the sale of a principal residence) to purchase a more expensive residence in order to defer tax on any realized gain. The rollover provision also applies to taxpayers holding property as joint tenants. In practice, a married couple will indicate on IRS Form 2119 ("Sale of Your Home")(2) that they sold their residence and their intent to purchase (if they have not already) another principal residence. If a new residence is not purchased in the same year that the old one is sold, a revised Form 2119 will be have to be filed in the year of purchase.(3) If a new residence is not acquired within two years following the sale of the old residence, then capital gains taxes (and interest) will have to be paid.

In a situation where a couple sells their residence, indicates on Form 2119 that they will purchase another residence and divorces prior to purchase, the situation is more complex. In that case, the replacement provisions of Code Section 1034 apply separately to each spouse. In other words, if each spouse has a 50/50 cost basis in the old residence (as is usually the case), then each spouse (in most common law states as well as community property states) is entitled to one-half of the sale proceeds. Each spouse must therefore purchase a new residence costing at least half of the sales price of the old residence in order to defer tax on the gain.(4)

Example: Warren and his wife Alisa bought their home in 1983 at an adjusted cost of $70,000. They owned the property as tenants by the entirety and lived there as their main home. In 1994, Warren and Alisa separated and sold their home for $120,000. Under the state law where they are residents, both Warren and Alisa are entitled to one-half of the sale proceeds, or $60,000. The realized gain on the sale is $50,000 ($120,000 less $70,000). Each spouse therefore has a $25,000 gain from the sale of the home. Before the end of 1994, both spouses purchase separate homes. The purchase prices of the new homes are $75,000 and $65,000. Since the cost of each new home was more than the respective shares of the adjusted sales price of the old home, both spouses must rollover his and her portion of the realized gain. Warren's new home has an adjusted basis of $50,000 ($75,000 minus 1/2 of $50,000 gain postponed) while Alisa's new home has an adjusted basis of $40,000 ($65,000 minus 1/2 of $50,000 gain postponed).

What are the consequences to a divorcing couple if, prior to divorcing, the couple sold their jointly-owned residence (at a gain) and only one spouse purchased another residence at a purchase price exceeding one-half of the sales price of the old residence? In other words, the couple indicated on their joint federal income tax return via Form 2119 that a replacement home would be purchased within the required time. However, only one spouse did so, at a purchase price less than the selling price of the old residence. In such a case, who is liable for any resulting capital gain taxes? In a recent case,(5) the IRS and the Tax Court ruled that a husband (who bought a replacement home) was liable for tax on the gain of all of his former wife's share of profits (she did not purchase a replacement home).

A possible solution to the problem of one spouse paying tax on the other spouse's realized gain is for the departing spouse sell his or her share immediately to the remaining spouse (similar to Peter and Michelle above). This procedure would be feasible even if the departing spouse has to take back financing for the other spouse. If the sale is in fact incident to a divorce, then in accordance with Code Section 1041, there will be no taxable consequences to either spouse. Another possible solution is that in the year of sale, the couple agrees to file as married filing separately. In this way, each spouse would be liable only for the rollover of his or her portion of the realized gain.

Division of Interests and Community Property States

It has been assumed that each spouse has a 50% interest in the jointly owned property. However, with some couples, tide to the residence may be in only one spouse's name. For example, prior to getting married, one spouse may have solely purchased the residence. Even though there are no income or gift tax consequences if title to the property is transferred in both spouses names, the couple may decide to retain title to the property in one name only. In that case, the provisions of Code Section 1034 apply solely to the spouse who owns the residence.

In terms of dual ownership, there could be situations where a form of ownership other than joint tenancy (e.g., tenants in common) may be feasible. An example of this situation is a recently married couple with each spouse having sale proceeds from previously owned residences. In this case, the required purchase price (in order to defer tax on any realized gain via Code Section 1034) for each spouse may dictate the form of ownership.

Example: John and Sherry recently got married. Prior to their marriage, John, with his former wife, sold their home for $150,000 (at a realized gain of $90,000) with John's portion of the sale proceeds/realized gain equal to $100,000/$60,000. Similarly, Sherry sold her residence that she owned jointly with her former husband at a sales price and realized gain of $80,000 and $30,000, respectively. Her share of the sale proceeds are 50%, or $40,000.

In order to avoid tax on their respective capital gains, John and Sherry purchase a new home at a cost of $140,000 ($100,000 plus $40,000). John's and Sherry's cost bases in their new home are $40,000 ($100,000 less $60,000) and $25,000 ($40,000 less $15,000), respectively. John and Sherry choose to title their property as tenants in common. John has a 71% ($100,000/$140,000) ownership while Sherry has a 29% ($40,000/$140,000) ownership.

The fact that spouses are not required to title their property as joint tenants is especially important for remarrying spouses when one or both spouses have children from previous marriages. These spouses may want to bequest property previously owned or bought in the future to their children. Therefore, such devices as a prenuptial arrangement and titling property as tenants in common may allow a spouse's children from a previous marriage to inherit a portion of newly purchased assets. However, the "awkwardness" of an arrangement whereby children from a previous marriage inherit a portion of a residence in which the surviving spouse lives may negate titling a principal residence in such manner.

In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin), the husband and wife are each usually considered to own half the community property. If a principal residence is sold, then each spouse would presumably automatically "receive" 50% of the sale proceeds to be reinvested in a more expensive jointly owned residence. In this manner, each spouse would be able to reinvest his or her share of the proceeds and defer tax on the realized gain. On the other hand, if the residence is sold and the couple divorces, then short of any divorce settlement, each spouse is responsible for reinvesting 50% of the sale proceeds in order to defer tax on any realized gain.

Summary and Conclusions

We have discussed some of the consequences to couples who are divorced or who are in the process of divorcing with respect to the retitling of property and to the rollover provisions of Code Section 1034. The issues covered are related to pre- and post-July 18, 1984, divorce settlements, titling of property, division of interests, and when the residence is sold (pre- or post-divorce). A recent ruling by the IRS and affirmed by the Tax Court indicates that spouses are jointly and severally liable for the tax on the realized gain from the sale of a jointly owned residence should either spouse not rollover his or her allotted portion of the gain into a new residence. Thus, husbands and wives who are in the process of separation must look carefully at the taxable consequences of their decision on how to deal with the principal residence that they jointly own.

References

1 Internal Revenue Code Section 1041

2 IRS Publication 523

3 Ibid

3 Internal Revenue Code Section 1034

4 Murphy, William (1994) 103 Tax Court No. 8

Edward A. Zurndorfer, CFP, EA, is accredited in accountancy and taxation by the Accreditation Council for Accountancy and Taxation (ACAT). An NSPA member, he has a private practice in Silver Spring, Maryland.