One of the toughest decisions a family has to make when faced with a divorce is whether to sell or keep the marital home. Consider the following: Mom wants to stay in the house, so the kids can stay in their schools, but Dad can’t continue to pay for the house and a place for himself.
Equitable distribution of property is governed by New Jersey (under N.J.S.A. 2A:34-23), which sets forth the factors that the court shall consider in determining the division of assets among the parties. Equitable distribution must be just that: equitable and fair. The prevailing theory of the courts is that both parties are entitled to half of the marital assets (in this case the home), unless a party is claiming that an asset or a liability is not marital and therefore exempt from equitable distribution.
From a financial perspective, dividing up assets is based upon the current value and does not often look at projected value based upon variables that are out of our control. However, lack of liquidity (access to cash), tax implications of both selling or keeping the house, and IRS rules should impact the decision-making process for those who may not have endless capital to divide up. With the home, there are 2 major impacts to being the spouse that is fighting for the house: your appreciated value in the home and the lack of full state tax deductibility against your federal income tax returns. What does that mean? Well, let’s go into these two scenarios in detail, with some examples.
In 2018, the IRS offers married individuals $500,000 free appreciation in their primary residence when they sell. What does that mean? If you bought a house and the value of it has gone up by $500,000 or less, you pay no taxes. For individuals, or post-divorce single tax filers, that $500,000 goes to $250,000. Let’s go through two examples:
- Example 1: You have a home you bought for $600,000. Today, it is worth $1.1 million. If you decide to sell the home while still legally married, your tax burden is $0.
- Example 2: The same example, and you sell it post-divorce. Your tax liability is likely 20 percent of $250,000 that you lose by divorcing and becoming a single tax filer. You now owe the IRS $50,000!
The same statutory factors that govern equitable distribution of primary residences also govern second homes. Your second home tends to be less difficult to divide during a dissolution because parties don’t have to address issues such as potentially changing a child’s school district. It’s important to remember that, for any second home, all appreciation is taxable.
You must live in a house for two out of the last five years (they don’t have to be consecutive years) to identify it as a primary residence. So, as an example, you have an investment property that up until three years ago was your primary residence. You can change it to your primary residence after a divorce, sell it and not pay tax on 100 percent of the gains. Or, if you have a second home that you moved into for a year while you remodeled your primary home within the past four years, all you need to do is live in it for a year as a primary residence to escape the 100 percent tax burden.
Another new and important factor to consider is that as of now, 2018, there is now a limit as to the amount of state income tax you can deduct from your federal income tax.
Well, what does that mean? In the past (post-1986), when you paid state and local taxes (or “SALT”), you were able to deduct any state income or residential taxes from your federal income tax. This deduction meant for those dollars that you paid state tax on, the federal government didn’t double-dip and take taxes on that dollar as well. Now, you are limited to $10,000 of deductions from a SALT deduction. So, if your residential taxes and state income taxes are more than $10,000 post-divorce, you are picking up the full double-dipped value of that on an annual basis. That decreases the longevity of whatever money you are earning, have saved and have divided over a divorce, especially since a single income is now responsible for it. So, when considering the house, who gets it, and should we keep or sell it, clients are looking for alternatives to lengthening their dollar by downsizing or moving to a lower tax state or town.
If one party wishes to keep the marital home, then the potential increased taxes must be considered when looking at their budget and whether he or she can afford to stay in the home.
When looking at the home value and the decisions around keeping or selling, these are some of the financial decisions you need to weigh out. Sometimes, from an emotional standpoint, keeping the house feels good; and, sometimes, it is essential because of keeping children in their school district. However, knowing what it is going to ultimately cost you gives you the knowledge you need to make the best decision. If you decide to keep the house knowing it is a poor financial decision, you can never look back and make the argument of ignorance. You will be prepared and armed with all of the options you have and how they will affect you.
How do I figure this out? Well, if you do your own taxes, you should have a good idea of what your exposure is going to be. If you use a CPA or accountant, they can give you an idea of what your exposure can be. Don’t stop there! Run some projections between the two scenarios. Some people are savvy enough financially to calculate the overall impact from a financial planning perspective. Ultimately, in decisions like this, you should put the burden on all of your licensed professionals. Include your financial planner. Consider an individual who is a licensed fiduciary and does financial planning. Good advice is worth paying for!
Robert J. Mascia is a partner at Green Ridge Wealth Planning. Francesca O’Cathain is a partner at Lesnevich, Marzano-Lesnevich, Trigg, O’Cathain & O’Cathain LLC.