One of the biggest decisions accompanying a divorce is what to do with your home. After all, a house not only often represents the largest asset that must be settled but also has significant emotional meaning—especially if you’ve both lived there for several years. In this post, we’ll lay out your options for what to do with your home in a divorce and considerations for each scenario.

Property division laws

Before we outline your options, it’s important to familiarize yourself with property division laws: as where you live can determine how your assets, including your home, are split.

If you do not have a prenuptial agreement, arm yourself with knowledge about your family’s financial situation and any applicable laws in the state where you file for divorce.

For example, nine states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) set out to ease the often-grueling experience of splitting assets between spouses by designating those gained during marriage as “community property” (meaning they’re owned equally by both spouses). As a result, assets that fall into this category are split evenly during a divorce. Examples of community property include real estate, personal property, savings and retirement accounts, and any debts acquired during marriage.

Meanwhile, “opt-in” community property laws in Alaska, South Dakota, and Tennessee dictate that assets are split evenly (if agreed to by both parties).

Every other state follows “equitable distribution,” meaning a judge will attempt to distribute assets as fairly as possible during divorce proceedings. Under these circumstances, no set rules determine which spouse receives what (or how much, for that matter).

If you own homes in more than one state, the location of your permanent legal residence determines whether you are subject to community property law.

Capital gains tax on your home sale

Before you decide what to do with your home, you should remain cognizant of potential tax implications: specifically with respect to capital gains. In our example, a capital gain is the profit you make from your home sale. To calculate this, take the price of your home and subtract your selling expenses and adjusted basis (meaning the amount you originally paid for the home plus any improvements made).

Generally, the transfer of property between divorcing couples is considered a nontaxable event. However, a few scenarios (which we’ll discuss shortly) can potentially trigger a capital gains tax.

As a matter of reference, capital gains taxes exist in two forms: short- and long-term. A long-term capital gains tax is imposed on profits from the sale of an asset held over a year. Rates are typically either taxed at 0%, 15%, or 20% of your profits, depending on your income and filing status. Short-term capital gains taxes are charged on profits from the sale of an asset held under one year. The amount taxed is the same as your ordinary income tax rate.

If you both decide to sell your home

One of the most common divorce settlement options is to sell your home and start the next chapter of your life with a clean slate. Those who mutually agree to go this route are assessed a capital gains tax. However, you can exclude a total profit of up to $500,000 ($250,000 each) from this tax if you’ve lived in the home for at least two of the last five years and you each used the home as a principal residence for at least two as well. A failure to meet these requirements means you’ll need to pay capital gains taxes on all profits since exclusions no longer apply.

If you’re an active military member away from your property due to permanent change station orders, you can extend the period up to an additional ten years: meaning you can exclude capital gains provided you’ve occupied your primary residence for at least two of the last 15 years.

If one spouse buys out the other

Another common scenario—especially when younger children are involved—is for one spouse to buy out the other. In a buyout, the amount paid to the seller is often half the amount of equity in the home. Consequently, the buyer (the person remaining in the home) may need to produce a significant amount of cash. This is often challenging, particularly if he or she doesn’t personally qualify for a cash-out refinance or the cumulative value of all other assets to be split—including savings accounts—isn’t enough to cover buyout costs. A gradual buyout presents one favorable alternative, wherein the buyer makes payments to the seller over an extended period of time.

Irrespective of buyout details, the spouse who elects to remain in the home is only subject to capital gains tax when he or she decides to sell. Once the home is sold, the spouse can exclude the first $250,000 in profits from taxes—provided he or she lived there for at least two years previously. If the spouse remaining in the home decides to remarry, the $500,000 exemption is once again a possibility as long as the newly married couple owns and lives in the home together for at least two years.

If you both maintain ownership, but only one spouse remains in the home

Another common option for divorcees is for both spouses to preserve home ownership but only one continues to live there. This is often the case when neither person can come up with enough money to buy out the other and selling isn’t an option—especially when kids are involved.

In the case of co-ownership, it’s important to account for several risks. First and foremost, a written agreement is necessary so that the spouse not living in the home doesn’t risk losing the $250,000 capital gains exclusion once it is sold.

You should also specify how long you’ll wait to sell (e.g., after children graduate from college), the parties responsible for upkeep and mortgage expenses, who will take the mortgage deduction (or if it will be split), and ensuing decisions if either person finds a serious partner or one spouse passes away as a co-owner.

Additional co-ownership risks include late mortgage payments that impact everyone’s credit, or even worse, if one spouse is sued by creditors or files for bankruptcy.

If you both maintain home ownership and decide to rent it out

Another co-ownership option—especially if you live in a big city with a strong rental market—is to rent out your home. While this scenario is less common, circumstances are favorable when the divorce is amicable and you and your spouse don’t foresee any issues joining forces as business partners. Nevertheless, make sure you execute a written agreement of each person’s responsibilities and corresponding impacts if one spouse decides he or she wants to sell. Also know that renting out your home sometimes means you’ll lose out on capital gains exceptions.

A few other considerations

Assets that are easily and quickly converted to cash are called “liquid” assets (examples include savings, checking, and investment accounts). On the flip side, illiquid assets take much longer to convert and include items such as real estate, vehicles, and collectibles.

The reason we bring this up is that if you receive mostly illiquid assets during divorce proceedings—even if the settlement seems equitable—you must remain cognizant of potential cash flow issues. Therefore, it’s important to ensure you have enough liquid assets to cover ongoing living expenses so you can avoid taking out a loan or—in the worst scenario—selling your home.

If you leave your marital home for your spouse or he or she buys you out, make sure your name is removed from the mortgage: as it will remain until the buyer (the spouse keeping the home) refinances, even if your settlement requires your ex-spouse to pay the mortgage. This is especially important if he or she can’t keep up with payments since you’ll remain liable—and thus possibly unable to purchase a new home on your own given these circumstances.

In sum: home options amidst a divorce

While it’s impossible to circumvent the emotions that accompany a divorce, you’ll want to avoid making decisions based on the same—especially with respect to your home, which is likely your largest asset.

———

Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.