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.