Capital Gains and the Family Home

The $500,000 exclusion from capital gains tax that is offered to married couples who sell a jointly-titled primary residence is a substantial benefit that needs to be analyzed in many divorces. In summary, the current IRS and California Franchise Tax Board regulations state that in order to claim the exclusion, the house must be held in both spouses’ names and the spouses must have resided in the home for at least 2 of the past 5 years on the date of the home sale.

The true “net” value of the $500,000 exclusion can be easily calculated. First, for the sake of creating a simple example, assume a federal capital gains rate of 20% (current for 2014). Next, assume a state income tax rate of 10%. Note that California does not have a fixed capital gains tax rate. Instead, California simply taxes capital gains as income. Now that we have settled on our tax rates, the calculation is straightforward:

$500,000 (exclusion amount) multiplied by the 30% combined (state and federal) capital gains rate = $150,000.

In short, the capital gains exclusion could easily be worth $150,000. Clients therefore need to think carefully about abandoning this benefit.

If the clients sell the home together pursuant to their divorce settlement, the answer is straightforward – the full $500,000 exclusion will apply (provided, of course, that the home is titled in both spouses’ names and the couple has resided in the home for the requisite period of time).

If one spouse retains the entire home as part of the settlement and title to the home is amended accordingly, the spouse who retains the home will be left with a $250,000 exclusion from capital gains.

Now that I’ve explained the basics, let’s analyze how the capital gains exclusion ties into the three standard arrangements regarding the disposition of a primary residence in a divorce:

Home sale: If the home is sold, the $500,000 exclusion will apply, provided that both spouses’ names are on title and they have lived in the residence for at least two out of the five past years.

Home buyout: If one spouse wishes to purchase the other spouse’s interest in the residence, the situation becomes a bit more complicated. The threshold question is this – Is it reasonable to apply any sort of capital gains exclusion calculation to the buyout? This is an open question, and opinions on this topic vary. Remember, capital gains tax only applies only if the home is subsequently sold. What if it seems likely that the home will never be sold by purchasing spouse?

Perhaps an example will help illustrate the conundrum. Assume that John and Jane Doe own a home that they purchased for $200,000 and is now worth $800,000. Quick math indicates that the $600,000 gain in the value of the home is subject to capital gains tax. Depending on the size of the capital gains exclusion that would apply (more on that later), the capital gains tax bill could be between $30,000 (a $500,000 exclusion) to $180,000 (no exclusion). Clearly whether to not to apply a capital gains exclusion analysis to the home buyout has significant financial implications.

First, let’s imagine that John and Jane Doe are nearing retirement, and Jane (who is doing the buyout) hopes to retire in the home and then leave it to her children upon her death. Applying a capital gains exclusion analysis to the home buyout may not be reasonable in this situation. After all, capital gains will likely remain a fiction, as she may not ever sell the home.

Now imagine that John and Jane Doe are in their early 40’s, and it seems likely that Jane will hang on to the house only until their youngest child graduates from high school, at which point she will sell the home. In this situation it seems quite likely that capital gains will become a real issue, and that she will be forced to pay some amount of capital gains tax when and if she sells the home. In this case, the question may be “What exclusion amount is reasonable to apply to the analysis?”

Remember, if John and Jane sell the home together, they will qualify for a full $500,000 exclusion from capital gains. In our Jane and John Doe analysis, applying the full exclusion results in $30,000 in capital gains tax at a 30% rate. However, if Jane sells the home years later (when the home is titled in her name alone), she will only be eligible for a $250,000 exclusion from capital gains tax (provided that she hasn’t remarried). This result in $105,000 in capital gains tax at a 30% rate.

Now for the problem: If a $250,000 exclusion is assumed, and the resulting capital gains tax is imputed to the home buyout analysis, John will be in a worse position than if the home was simply sold at the time of settlement, simply because a $500,000 exclusion would apply if the home were sold at settlement. However, if a $500,000 exclusion is assumed, and the resulting capital gains tax is imputed to the home buyout analysis, Jane’s future capital gains tax may well exceed the amount that was assumed at the time of divorce (i.e., she will have paid John too much for his share of the home). What is equitable in this case?

Truthfully, what feels “equitable” to clients will depend greatly on their circumstances and best good faith projections about their future financial choices. After all of this analysis I am simply positing that there is no right answer. That being said, I hope that this explanation of the dilemma at least helps you think through the implications of the capital gains tax exclusion on a home buyout analysis.

Co-ownership: Occasionally clients prefer to co-own their home for a period of years. This is a challenging alternative in some instances because it requires cooperation and keeps former spouses financially tied together in a way that may not be desirable. Nonetheless, if one spouse can’t afford to purchase the other spouse’s interest in a residence, but they both wish to retain the home for the sake of the children (perhaps a child is a few years shy of high school graduation), co-ownership can make sense. This quick analysis isn’t intended to cover all of the implications of co-ownership, but instead simply offers a very quick glance at the capital gains tax implications of co-ownership.

In short, so long as two requirements are met, former spouses who co-own a residence will continue to qualify for a $500,000 exclusion from capital gains tax, even if only one spouse lives there. The two requirements are as follows: (1) both spouses must remain on title, and (2) the divorce decree must state that one spouse is granted the right to remain in the residence as an element of the settlement. If there isn’t a divorce decree that specifies that one spouse has the right to remain in the residence, the “out spouse” will not be entitled to his or her $250,000 exclusion.

Spousal Support and the Marital Standard of Living

By David Magnuson

As a mediator, my goal is to keep my clients out of court, and as a result, I strive to shepherd my clients through a practical, budget-based discussion of spousal support. That being said, what happens when the budget-based approach doesn’t produce a tidy result? In other words, how do we navigate the sometimes turbulent waters of a spousal support discussion when it becomes clear that either (1) my clients have more than enough income to cover both sets of living expenses, or (2) more commonly, the combined income of my clients is substantially less than the combined costs of maintaining two households?

First, let’s analyze the less painful of the two scenarios – i.e., the scenario in which the parties’ combined income is more than enough to cover any and all reasonable living expenses. For example, imagine that Sally Shoemaker is a 52-year-old Silicon Valley executive whose average annual compensation is $1,500,000. Further, imagine that due to some very lucrative stock options resulting from a prior employer’s initial public offering, Sally has accumulated a net worth of $30,000,000. Next, imagine that Sally’s annual living expenses amount to $150,000 and the living expenses of Jack, her husband, also amount to $150,000.

If all of the $30,000,000 nest egg that Sally has accumulated is considered community property, each spouse will leave the marriage with $15,000,000. Now imagine that each spouse will live in a residence worth $2,000,000 and that each of them will also have $1,000,000 in a retirement account. The residences clearly aren’t producing income, and the retirement accounts can’t be accessed without penalty. (In other words, while ideally increasing in value each year, the retirement assets aren’t producing real income). As a result, each spouse has roughly $12,000,000 in investable (liquid) assets. Assuming that his or her respective brokerage account returns 4% each year, each spouse should have annual investment income of $500,000.

The conundrum should immediately become apparent. Jack’s expenses are $150,000 per year and his investments alone should provide him with $500,000 per year in income. Sally argues that Jack’s investment income dramatically exceeds his monthly needs. She has heard that the philosophical basis of spousal support is tied to helping the supported spouse attain the standard of living to which he or she become accustomed during marriage. Jack can pay all of his bills (and then some) with his investment income. Sally therefore feels that spousal support is unnecessary – worse yet, she feels that any award of spousal support is patently unfair.

What to do? Sally can clearly show that Jack doesn’t “need” extra cash on a monthly basis. That being said, as a stay-at-home father who raised three children, Jack believes that he was instrumental in supporting Sally’s career and he therefore deserves some of Sally’s income for an extended period of time.

Legally, the discussion may slip into an analysis of the “Marital Standard of Living” (or MSOL, if you are a divorce nerd). How does the court determine a divorcing couple’s MSOL? Well, for one, accountants are typically brought into the discussion. A recent discussion with a highly regarded Silicon Valley accountant who specializes in divorce matters suggested that two models are frequently used: (1) the “expense model,” or (2) the “income model.”

Under the expense model, accountants crunch data to determine a reasonable average set of expenses for the couple and then discount the number as appropriate to account for a single spouse’s share of said expenses.

Under the income model, accountants crunch data to determine an average income for the couple and then discount the number as appropriate to account for a single spouse’s share of said income.

At first blush, the expense model seems to heavily favor Sally, while the income model seems to heavily favor Jack. That being said, in California a judge is able to consider the ability to save as an element of the couple’s Marital Standard of Living. This means that the expense model could have a “savings” element built into it.

Regardless, where does this leave us? In a bit of a mess, I’m afraid. This is a classic example of why the bills of divorce litigators can run into the hundreds of thousands of dollars (and even millions of dollars in some sad cases). Does the right answer lie somewhere between the results of the expense model and the income model? Perhaps. But what would happen if the issue was presented to a judge for his or her determination, you might ask? If the answer was the result of the mechanical application of California law (like a basic child support calculation), I could tell you with certainty. In reality, after hearing the expert testimony of accountants for both clients and taking their respective attorney’s input into consideration, the judge would demonstrate that family court is a court of equity – in other words, the judge has a great deal of discretion in setting spousal support. Knowing this, my mediation clients prefer to shape their own destiny by doing the hard work of sorting through their desires and expectations with a neutral third party. If nothing else, at least they will recognize the result.

Now let’s imagine a more common scenario in which Sally Shoemaker is a teacher who earns $60,000 per year and Fred Shoemaker is a carpenter who earns $25,000 per year. Unfortunately, Sally and Fred are mortgaged to the hilt, have virtually no assets, and are burdened with a combined monthly budget that exceeds the after-tax sum of their combined incomes. Now that they are parting ways, the cost of maintaining two households is substantially greater than their combined incomes. What to do?

The short answer to this particular conundrum can be summarized in a few words: the clients must “share the pain.” Presuming that both Sally and Fred are earning to capacity and their respective expenses after separation don’t differ substantially, an award of no spousal support might indeed be an injustice to Fred. Sally may break even while Fred my fall short of his monthly budget by a huge margin. Conversely, too large an award and Sally will find herself descending into debt each month at a rate that exceeds the rate of Fred’s descent into debt.

Application of the expense model won’t likely prove particularly useful – we already know that neither spouse will be able to come close to meeting his or her monthly expenses. The income model, however, might indeed prove a useful means of coming up with a spousal support award.

Philosophically, this scenario is a bit easier to digest than our first scenario. A financial planning discussion will uncover two obvious (but challenging) solutions: (1) each spouse will need to strive to increase his or her income, or (2) each spouse will have to work hard to decrease his or her living expenses. Ideally, of course, my clients who face this situation will do both, and spousal support will be adjusted over time according to the results of their efforts. In the meantime, though, “sharing the pain” by equalizing income to some degree through a spousal support award is likely the answer.

Divorce; your choices and your children

By Lynn Waldman, MFT

Reality starts to slowly set in; your marriage is over, as you begin to contemplate the divorce process, you may struggle with the idea of what life will be like as a divorced, single parent. Many things will change, but your priority is your children and maintaining their normalcy and consistency. You contemplate the best ways to co-parent your children, but so does your soon to be ex-spouse and you find you are at an impasse about how to proceed. Both of you may consider hiring an attorney; the divorce process can be so overwhelming, especially as you each have different ideas about how to share the children.

Maybe you have been the stay at home parent, responsible for caring for you children every day. As their parent, you have taken them to all of their doctor appointments, prepared most of the meals, driven them around to different sporting events and activities, attended school meetings, dried their tears, and celebrated their triumphs. Therefore, you may believe you should care for the children the majority of the time. Your spouse points out that he has coached the kid’s soccer teams, taken them to other sporting events, helped with homework, paid the mortgage and medical bills, paid for family vacations, even found a way to pay for private school because you both wanted the children to have the best education possible. He believes he could not have spent as much time with the children because he was earning a living to finance the family lifestyle, a plan you once both agreed to, but that does not mean his relationship with the children is not as important or as relevant as yours; he would like to care for the children as often as you do.

In many similar situations, parents wonder, “Why does the mother want to push me out of my kid’s lives? Why does the father all of a sudden want to start parenting the kids when he showed no interest when we were together?”

When parents begin to discuss a parenting plan, it can be one of the most difficult, emotional, and frustrating matters for divorcing parents to settle. The process can become even more complicated when parents realize their parenting time is a determining factor in child support.

When parents are at odds, they are more susceptible to fall into a mindset of wanting to win… at all costs. They may decide to proceed with a litigated divorce and see this as their only option. They forget their original intent was for the well-being of the children, and maintaining the family’s consistency and normalcy.   The parents’ disagreement ends up having the opposite effect and negatively impacts the children and their relationship with both parents. As a result, children feel pulled in both directions; they do not want to hurt either of their parents. Now, the weight of the world is on their little shoulders as they feel they are in the middle of mom and dad’s divorce.   Commonly, the outcome is children’s grades start to fall, they become aggressive and sassy, or quiet and shutdown. Children may end up in counseling focusing on difficult feelings they have about their parent’s contentious divorce.

Years later, parents who have litigated their divorce anecdotally report regretting their decision to fight it out in court. Upon reflection, they say their children were damaged, they were damaged, and they ended up spending excessive amounts of money.

Many parents are often thrilled to learn there is another option. That option is mediation, and it can work for you! Parents can mediate their divorce, avoid the heart ache, trauma, and emotional roller coaster of litigation and court involvement. Mediation is an opportunity to work through disagreements, no matter how contentious, even if you think agreement will never be possible. Parents are finding out they can work with a mediator and realize it is one of the best decisions they could make in the face of divorce.  A well-trained mediator (particularly a therapist-mediator) understands the emotional aspects of divorce, it’s impact on the parents and children, and the importance of guiding the family through the process with dignity. Mediation allows you and your soon to be ex-spouse to maintain your authority over your life, have your voice heard and understood by a therapist, and keep the best interest of your children in mind.

For more information about your options and to discuss your situation further, please see the California Divorce Mediation website at www.cadivorcemediation.com and feel free to contact one of our experienced mediators for a free, one hour consultation.