New Tax Law Alters Divorce Planning For Marital Residences
By Stacy E. Schwarz
As appeared in The Philadelphia Lawyer
Philadelphia Bar Association Quarterly Magazine, Summer 1998, Vol, 61 No. 2
Couples in the throes of divorce who succeed in overcoming the psychological, emotional and financial challenges of marriage dissolution may be surprised several years later to discover an IRS representative communicating the not-so-welcome news that their past is not as far behind them as they had thought. The emotional cycle of mourning, reflecting and healing and the ultimate transition to the readjustment of life often distracts the couple from paying attention to the tax aspects of their property division. Because divorce attorneys are the somewhat emotionally detached disciples of reason and the human medium to the financial practicality of divorce, it is imperative that they structure divorce settlements and manage divorce litigation in a manner that maximizes the client's financial interests and tax benefits. The tax ramifications in divorce cases are of paramount importance, and to think otherwise is to invite an unwelcome guest: the IRS auditor.
The principal residence or marital home usually is the spouses' most significant marital asset subject to property division. Consequently, when how or to whom the marital home is disposed must be carefully planned when negotiating structuring divorce settlements. The Taxpayer Relief Act of 1997, passed on August 5, 1997, eases the tax treatment of capital gains realized from the sale or exchange of a principal residence, and makes planning amore favorable option than under prior law.
This article addresses the applicable Internal Revenue Code provisions affecting the disposition or transfer of the principal residence and explains the general advantages and disadvantages of the legislative changes. Thereafter, common scenarios in divorce settlements or litigation relating to the principal residence are analyzed under the old and new provisions.
Transfers of Property
Under Section 1041, no gain or loss is recognized on transfer of property incident to divorce. A transfer of property incident to divorce is one that either occurs within one year after the date on which the marriage ceases ir related to the cessation of the marriage.1 A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument2 and the transfer occurs within six years of the divorce.3 These transfers are treated as gifts for income tax purposes (no gain or loss is recognized) and the transferee of the property takes the transferor's carry-over adjusted basis in the property.4
A common provision in property settlement agreements is that the marital home/principal residence is transferred to one spouse unconditionally instead of being sold to a third party. Thus, no gain or loss would be recognized by either spouse. Complications arise when the parties are required by the court or agree to engage in a transaction other than a simple transfer.
Old Section 1034
Before the enactment of the 1997 legislation, any gain from the sale of the marital residence was included in the gross income of one or both of the spouses as a capital gain5 unless that person qualified for Section 1034 non-recognition treatment. Under Section 1034, no gain is recognized on the sale of a principal residence at least equal in cost to the adjusted sales price of the old residence is purchased and used by the person within either two years before or after the sale of the old residence. Gain from the sale was recognized only to the extent that the adjusted sales price of the old residence exceeded the cost of the new residence.6 Consequently, the basis of the new residence equaled its cost, reduced by the amount of gain recognized on a sale or exchange of the replacement residence in a transaction not covered by section 1034.7 Thus, the gain is deferred, and the provision was called the "gain rollover rule".8
Pre-amended Section 121 provided an individual a once-in-a-lifetime election to exclude up to a $125,000 of capital gain recognized on the sale of a principal residence. However, this exclusion was only available to taxpayers who reached age 55 before the sale and owned the property and used it as a principal residence for periods aggregating at least three of the five years before the sale. If a husband and wife filed a joint tax return, only one of the spouses needed to have attained age 55 before the sale date to qualify for the $125,000 exclusion. This excludable amount applied to all taxpayers except those married who filed separately, for whom the exclusion was $62,500. Additionally, if either spouse had previously used the exclusion in a prior marriage, that prior use precluded use of the exclusion in the current marriage.
The Taxpayer Relief Act of 1997 repealed the Section 1034 gain rollover rule and modified Section 121 to provide an exclusion of up to $250,000 of capital gain realized on the sale or exchange of a principal residence to all taxpayers regardless of their age. To qualify for the exclusion, the individual need only own and occupy the residence as a principal residence for periods aggregating at least two of the five years before the sale or exchange.9 This exclusion is limited to one sale or exchange every two years.10 However, sales before May 7, 1997 are not taken into account in determining if more than one sale has occurred in a two-year period.11 For married individuals, the excludable amount is up to $500,000 if tax returns are filed jointly,12 either spouse meets the ownership requirements,13 and neither spouse is ineligible for the exclusion because of a sale or exchange within the last two years.14
There is also a prorated exclusion provision in Section 121 that the tax-payer can use if he or she does not meet the ownership or residence requirements because of a change in employment, health or unforeseen circumstances.15 If the taxpayer qualifies, the excludable amount equals the amount that would otherwise be excluded, multiplied by a fraction, the numerator of which is the period of time the taxpayer owned and used the home as the principal residence and the denominator of which is 24 months.16
Perhaps the most significant change of Section 121 benefiting divorced or soon-to-be-divorced taxpayers is Section 121(d)(3)(B). Under this provision, an individual is treated as using property as a principal residence for any period of ownership during which the spouse or former spouse is granted use of the property under a divorce or separation instrument.17
This new Section 121(d)(3)(B) provision will save many taxpayers from paying exorbitant capital gains tax. Under the old law, these taxpayers were denied the exclusion when they moved out of their former marital residence pending their divorce if more than two years elapsed before the residence was sold, because they could not claim the property as their principal residence at the time of the subsequent sale and the two-year gain rollover period had expired.18
It is not unusual for a spouse to wait years after moving out for a divorce (and ensuing sale of the residence). The length of the delay depends on the parties' attorneys and opposing party's cooperation in effectuating a property settlement, the time factor of discovery and the congested court dockets. Accordingly, if the divorce process is prolonged, the new law permits a spouse who moved of the marital home to qualify for gain exclusion. This new provision also resolves the prior tax law problem faced by taxpayers who, pursuant to the divorce decree, continued to own the marital home but granted exclusive possession to their former spouse until the parties' children went away to college (at which time the former marital home would be sold). The exclusion is available to the non-possessing spouse upon sale of the property assuming both the owner and the former spouse meet the ownership and use requirements respectively. However, since a divorced couple cannot file a joint tax return, the exclusion is limited to $250,000.19 Even if the selling spouse had remarried and filed a joint tax return with a new spouse, the exclusion would still be limited to $250,000 since married taxpayers are eligible to claim $500,000 exclusion on the sale of their jointly owned principal residence. Married joint filers not sharing ownership of a principal residence can each claim $250,000 exclusion on the sale of their own respective residences.20
The relief provided by the new Section 121(d)(3)(B) is illustrated by how it would have changed the result in Perry v. Commissioner. 21 The husband left the marital home and gave possession to his wife pursuant to a divorce property settlement agreement. The court held that "a house which a party to a divorce has agreed shall be the exclusive residence of the other spouse cannot, during the period covered by that agreement, be the 'principal residence' under Section 1034(a) of the person who has agreed to move out". 22 In the Tax Court, the husband had argued the sale of the home was prevented by the external circumstance out of a taxpayer's control, but the Tax Court held that divorce is not the type of external circumstance that allows a taxpayer not in possession of a home to be deemed a resident therein for purposes of Section 1034(a). Under new Section 121(d)(3)(B), the husband would be treated as satisfying the ownership and use requirements when the home eventually is sold.
No Pressure to Reinvest
One of the effects of the amendments to Section 121, which benefits both divorcing and non-divorced taxpayers, is the repeal of the requirement that they reinvest the proceeds from the sale of the principal residence in a replacement residence.23 Thus, divorcing couples whose financial fortunes are adversely affected by the cost of divorce, the division of property and the inefficiencies of splitting a household no longer need worry about finding a replacement residence in what often had been a fairly short time period.
Record Keeping Relaxed
To the extent that the process of divorce exacerbates the challenges of maintaining financial records, divorcing couples should find some solace in the observation that "perhaps the most attractive feature of the new approach to taxing the sale of homes is that it now simplifies the record keeping requirements for most taxpayers". 24 The risk that documents, receipts and other papers accumulated over the years to establish the cost of home improvements in order to reduce realized gain might get list during one or both of the spouse's move has become less of a concern, though it still exists if it appears that more gain will be realized than is eligible for exclusion. Likewise, if one spouse has possession of all the parties' paperwork and uses that possession as leverage for other issues incident to the divorce, there is now less opportunity to take advantage of the other spouse. However, individuals should keep records of capital improvements if any of the following situations might exist:
- The individuals plan to live in the residence for a long period of time; or
- The residence is "rapidly appreciating in value"; or
- The individuals might not own or use the residence long enough (i.e. two aggregate years of the proceeding five years before the sale) to qualify for the exclusion.25
Many divorce property settlement agreements provide for the transfer of the marital home to one spouse, typically the primary custodial parent of the children Accordingly, if the principal residence/marital home is transferred to one spouse (assuming within time restraints and requirements of Section 1041(c)), there is no recognition of gain under Section 1041. Section 121 does not even come into play. The transferee spouse takes a carryover basis in the property transferred (the carryover basis is the home's basis prior to the transfer) even if cash or other assets are transferred by the transferee of the house in exchange for the house. Consider a husband and wife who divorce on January 15, 1998. On May 1, 1999, the husband transfers his interest in the house to the wife. Although the transfer occurs one year and four months after the divorce, as long as the transfer is made pursuant to the property settlement agreement of divorce decree (qualifying for the "related to the cessation of the marriage" standard under Temp. Reg. 1.1.041-1T(b) Q&A-6&7), there are no income tax consequences and such a transfer is considered a gift for income tax purposes. 26 Such a transaction would generate the same tax consequences under repealed Section 1034 and pre-amended Section 121 as well as modified Section 121. Obviously, the new provisions would come into play upon a subsequent sale of the home by the transferee spouse who would benefit from the new generous excludable amounts.
Possession/Use of Home
Another common scenario in divorce situation, typically when children are still young and have not yet gone off to college, is to give possession of the residence to the custodial spouse for a certain period of time while leaving title in the non-custodial spouse. Such a provision in a property settlement agreement might provide for the sale of the home at a later date or for possession to revert back to the spouse who retains title. Under repealed Section 1034 and pre-amendment Section 121, the non-possessing spouse was typically denied gain rollover because the residence did not constitute his or her principal residence for the requisite period of time.27 However, in light of Section 121(d)(3)(B)28, the spouse who does not remain in the house can still benefit from the new provisions.
Continued Joint Ownership
The parties may decide to continue to own the residence in joint names while one spouse moves out and lives elsewhere. The property settlement agreement may provide for the sale of the home at a future time.
Under repealed Section 1034, the spouse who left the home would likely not qualify for gain rollover because of a failure to satisfy the two-year requirement, and also would likely not qualify for pre-amendment Section 121 gain exclusion because of a failure to satisfy the three years use/occupancy requirement. Once again, 121(d)(3)(B) provides a solution to this old recurring problem, permitting both ex-spouses to benefit from the exclusion. However, the divorced couple cannot file a joint return and the exclusion is limited to $250,000 each. Even if the ex-spouses are married to new spouses, the exclusion is limited to $250,000 because the two people who own the residence are not filing a joint return with each other. Of course, if the husband or wife has already used the Section 121 exclusion within the last two years,29 that spouse would not qualify for any exclusion when the marital residence is sold.
Occasionally, both spouses move out of the marital home pending their divorce, perhaps because neither spouse wishes to be reminded of life with the other spouse in the marital home, or perhaps for employment, financial, personal or family reasons. If the division of marital assets is still being disputed by the parties, the clock is ticking for purposes of the two-year-owned-and-used-as-a-principal-residence requirement of Section 121. Example: Husband and wife leave the marital home on January 1,1998. The divorce settlement negotiations and litigation drag on until January 1, 2004, and a gain of $500,000 is recognized. Since neither party occupied or used the home as a personal residence for at least two of the five years preceding the sale, each party will recognize $250,000 of gain. In order for the parties to avail themselves of the new modified Section 121 exclusion, the house would have to be sold by January 1, 2001, because that permits the maximum allowable three-year window of vacancy time. The two-of-five-year rule permits a maximum of three years of vacancy, which in this example would be the years 1998, 1999 and 2000.
Considering the negative tax consequences if the sale of the residence takes place after January 1, 2001, it is conceivable that one spouse could try to stick the other with the gain-filled house in exchange for other assets not carrying inherent built-in gain or other tax burdens. Therefore, when planning divorce property settlements while the house is vacant, the three-year window period should be carefully calendared.
It should also be noted that the two-year ownership and use requirement does not need to be two consecutive years, but two aggregate years. Therefore, all periods of time during which the home is used as a principal residence are added together to determine if the two-year period is satisfied. Accordingly, it is imperative that the dates of use and nonuse are carefully monitored in order to ensure qualification for the exclusions.
The divorce Process is loaded with emotional and financial stress. Helping clients maximize the benefits if the tax laws regarding their principal residences plays a major role in easing the financial burden during the trying time of divorce.
The Taxpayer Relief Act of 1997 remedied many of the problems and deficiencies inherent in prior tax law. Because the principal residence is probably one of the most significant marital assets subject to property division, careful scrutiny of the tax implications by divorce attorneys is imperative. Divorce attorneys can help pave their clients' way to a smoother transition by providing quality financial and tax planning.
Note: The author wishes to thank Professor James Edward Maule of the Villanova University School of Law Graduate Tax Program for his comments on this article