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Divorce and Real Estate: Avoiding a Tax Surprise

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Expert analysis of residential, rental and commercial properties during a high net worth divorce is key to aligning assets with your goals — and avoiding unwanted tax surprises.

The division of real estate during a divorce settlement can be an emotional, stressful experience, and fraught with complexities. Indeed, valuable properties often have both strong emotional and practical attachments for one or both parties — and these considerations can drive important decisions related to division. It is not uncommon to underestimate, or table for later, gaining an understanding of the full spectrum of financial and tax considerations. A detailed financial analysis of each property, however, can be enormously beneficial to better aligning the pool of assets with the goals of both parties, optimizing tax planning and ensuring an equitable settlement.

The potential for new tax increases has also created some urgency around real estate and tax awareness. At the time of writing, Congressional Democrats had most recently proposed raising the capital gains rate from 20% to 25%, effective for sales after September 12, 2021. Although, if the proposal were enacted as written, the opportunity to realize gains at the current rate has passed, the Congressional debate surrounding new tax laws is very much in flux. Additionally, several states are considering raising taxes on high earners. While the pathway forward for such legislation remains unclear in all cases, we believe some degree of tax change is likely.

Below, we discuss several common tax pitfalls in the division of residential, rental and commercial real estate investment properties — and the steps you can take to avoid them.

Residential Properties: Navigating a Complicated Emotional and Financial Decision

The family home is often your most personal asset and, in the midst of a divorce, holding onto it is frequently seen as an important source of stability. That may well be the case. From a financial standpoint, however, whether or not to keep the home is a complex decision with meaningful consequences. Before you decide to retain the marital home, it is important to answer the following questions in order to determine if you are positioned to remain in the house long-term:

  • Will you be able to afford the property taxes, mortgage payment, insurance, utilities and maintenance?
  • Will you be able to afford major repairs?
  • Do you have the liquidity to make desired or necessary improvements
  • Will you encounter difficulties removing your former spouse from the mortgage? Depending on your income, refinancing could be a challenge.

The answers to these questions can provide insight into your ability to keep the house for the long-term — and it is critical to remain aware of the impact of capital gains taxes on a potential sale.

For example, married couples — and even ex-spouses who still co-own the property — have up to $500,000 of capital gain exclusion when they sell a principal residence within certain time frames. Sole owners have only $250,000 in exclusion. This means that you could have a far more advantageous tax situation if you agree to sell the home as part of the settlement rather than keeping it, only to decide to sell post-divorce. As illustrated below, the numbers can add up:

In this scenario, if the property was sold as part of the settlement, each party would only owe $30,000 in taxes — a far cry from the $110,000 owed if one of the parties keeps the martial home as part of the settlement, only to sell it later. Additionally, if the property was sold as part of the settlement, the parties could potentially split the transaction costs, which can run into the hundreds of thousands on multi-million dollar properties.

California Case Study

A recent scenario involving a California vacation home illustrates the point perfectly. One spouse wanted the $6,000,000 vacation home because it was “the better property.” Unfortunately, the annual expenses to carry the property totaled just under $300,000 — which was more than 60% of the receiving spouse's income. The writing was on the wall that this would not be a long-term hold.

Fortunately, the property had a fantastic beachfront location that would garner substantial buyer interest. When the property sold, however, the federal and state capital gains taxes rose to more than 28% of the net sales proceeds. Ultimately, as illustrated below, the taxes, transaction costs and repaying the mortgage netted the spouse just under $2,000,000 — which was $1,000,000 less than the value attributed to the property in the settlement.

If the couple had sold the property as part of the divorce settlement, the net proceeds would have been the same. But with actual net proceeds closer to $2,000,000 than the attributed value of $3,000,000, other assets could have been identified to make up the difference in the settlement.

Rental Properties and Commercial Real Estate: Aligning Assets with Goals

With income-producing properties, there are more factors to consider than just taxes after a sale; there are often management and control issues to navigate as well. In either case, having the right team of financial experts to analyze the underlying documents of each property, such as property financial statements, loan documents, leases, ownership agreements and tax returns, is essential to an equitable settlement and avoiding unwanted surprises.

In many divorces involving a small number of real estate investment properties, these assets are simply split 50/50, with one spouse continuing to manage the properties post-divorce. While this plan can work, the couple never achieves full separation. If properties are owned as tenants-in-common, for example, multiple decisions need to be made by consensus, since each spouse owns their own interest. If the properties are owned in entities such as LLCs or limited partnerships, transparency for the non-managing spouse can be a concern.

Additionally, capital gain tax is recognized when a property is sold. While capital gains taxes can be deferred in a “like-kind exchange” (IRC sec. 1031) if rolled into a replacement property, the ex-spouses must work together when identifying and acquiring the new property. Thus, the spouses do not have the ability to fully separate their financial lives without incurring taxes.

One solution may be to conduct a deeper analysis of each property prior to division and develop a separation plan. This entails working with your financial advisors to analyze property cash flow and reviewing property documents such as leases, ownership agreements and loan documents. Doing so can reveal that some assets better meet the specific financial goals of the spouses. Instead of simply splitting assets 50/50, identifying specific assets to allocate between spouses allows each party to control their own financial future. This avails each party to the 1031 exchange option mentioned above, since they have full control over individual properties.

Complex Real Estate Holdings: the Value of Expert Analysis

One divorce case where the husband was a real estate developer involved more than 50 limited partnerships that he had invested in over the course of a 30-year career. Many of these investments were non-controlling interests, and almost all of the partnerships had debt. Although the wife desired complete financial separation, under the circumstances a 50/50 split seemed like the most logical choice.

Northern Trust’s commercial real estate experts conducted a deeper analysis, which revealed that some of the investments offered more reliable income, while others offered more potential for capital appreciation. It was ultimately decided that certain investments producing predictable income were more suitable for the wife to own, while the husband’s goals were better aligned with properties that were expected to appreciate.

Following the divorce and separation of the properties, the ex-wife's consent on major decisions like refinancing properties would not be necessary, and she would have the ability to make separate financial plans with a pool of assets that better fit her goals. This allowed her to diversify her assets and lower her exposure to real estate risks by selling some properties and refinancing others.

Conclusion

Divorce often presents multiple complex issues competing for your attention. Failing to engage the right financial experts prior to finalizing your settlement can result in an inaccurate assessment of tax-adjusted values as well as undesirable tax surprises. The growing potential for capital gains tax increases make awareness of this issue even more vital.

We believe that careful consideration of each client’s financial goals is essential to identifying a mutually beneficial division of assets. Commercial real estate, in particular, is a complicated asset class that requires expertise to manage and careful analysis to identify tax-saving opportunities. It can be heart-wrenching to sell a beloved residential property — but it can also be the best financial decision. A team that includes advisors with expertise in this asset class is crucial to building a plan that puts you on the strongest footing possible for your next chapter.

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THE NORTHERN TRUST INSTITUTE

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Disclosures

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

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