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Feb 2022 : Sale of Marital Residence in a Divorce Context – Taxation of Gain

Posted by Joseph W. Cunningham, JD, CPA

View / Download February 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

As is generally known, prices of homes in Michigan have increased substantially in the last couple years. Sellers are frequently receiving multiple offers above their asking price.

So, most homes sold in these conditions will result in considerable gains over what the seller paid for the house.

Because of the recent surge in home sale prices, the following summarizes how the gains on residential sales are treated for tax purposes in a divorce context.

General Rules of Taxation on Principal Residence Sale

There is an exclusion for tax purposes of gain on the sale of a principal residence – up to $250,000 for qualifying single taxpayers and $500,000 for qualifying married taxpayers who file a joint tax return.

To qualify for the exclusion, a single taxpayer must own and live in the home as a principal residence for two of the five years preceding the sale.

A taxpayer who fails to satisfy the use requirement due to a change of employment, health problems, or other unforeseen circumstances is allowed a percentage of the exclusion equal to the percentage that the two years ownership and use requirements are met.

For a married couple, one spouse must satisfy the two out of five years ownership requirement, but both must have lived there for two of the five years preceding the sale.

A taxpayer may use the exclusion each time a home is sold, provided two years have elapsed since the last sale.

As a practical matter, even with the recent increase in home prices, the lion’s share of gains will not exceed the exclusion. However, particularly for houses held for many years in upscale areas, gains might be higher than the exclusion.

Sale In A Divorce Context

Home Sold While Married

The marital status on the date of sale determines whether the parties are married for purposes of the exclusion.

If parties are married on the date of sale, the $500,000
gain exclusion is available provided:

  • The parties file a joint return for the year of sale. This means that the divorce does not occur in the year of the sale.
  • One of the spouses satisfies the two out of five years ownership requirement
  • Both satisfy the two out of five years use requirement.
  • Neither has used the exclusion within two years preceding the sale.

Special Rules Applicable to Divorce-Related Sales

  • Attribution of Ownership – When an interest (e.g., fifty percent) in the marital residence is transferred from one spouse to the other pursuant to the divorce, the transferor’s period of ownership passes with the property to the transferee.
    Example:

    • H and W agree that she will transfer her 50% interest in their home to him.
    • H decides to sell the house 2.5 years after the divorce.
    • W’s period of ownership is transferred to H with respect to the 50% interest she transferred to him.
    • Thus, he satisfies the two out of five years ownership requirement and, hence, qualifies for the $250,000 exclusion on the entire gain, not just the 50%.
  • Attribution of Use – If it is expressly provided in the divorce settlement that one spouse is entitled to remain in the home until it is sold (often when the youngest child is emancipated), that spouse’s use is attributed to the other (who is usually out of the house and would not otherwise qualify).
    Example: In their settlement, H and W agree that:

    • They will continue to jointly own the house;
    • W will live there with their child; and,
    • The home will be sold and proceeds divided in four years when their child graduates from high school.

Provided that the divorce settlement expressly provides for W’s right to remain in the home until it is sold, then her occupancy is attributed to H for purposes of the two years use requirement. Thus, the $500,000 exclusion is available.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Sale of Marital Residence in a Divorce Context – Taxation of Gain”
View / Download February 2022 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “Feb 2022 : Sale of Marital Residence in a Divorce Context – Taxation of Gain”

Dec 2020 : Michigan Court of Appeals Rules on Dispute on Calculation of Interest on a Divorce-Related Installment Obligation and, a Better Way to Do It. Elam v Elam, Mich App 348201 (10/15/20)

Posted by Joseph W. Cunningham, JD, CPA

View / Download December 2020 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

Facts:

  • As part of their 2005 Settlement Agreement, H was obligated to pay W $1,000 principal & interest payments a month over 12 years on a $175,000 debt to her.
  • The obligation was to be secured by certain real property and, further, H was to sign a “mortgage note” – which he never did.
  • Interest on the obligation was provided as “accruing interest as a traditional mortgage note in the amount of 3.75%.”
  • After the final payment in 2017, W claimed that H owed her over $50,000 in accrued interest.
  • H claimed that a simple interest rate should apply resulting in accrued interest of $6,250.
  • W’s expert testified that “a traditional mortgage note meant a bank mortgage calculated under an amortized interest schedule” – which means interest compounded monthly.
  • H’s expert testified that, without a note, he could not determine the interest owing.
  • In short, the trial court applied laches and ruled that, because W did not seek to enforce the provision that H sign a note, H’s interest calculation should apply.
  • W appealed.

Court of Appeals Decision

  • In pertinent part, the Court ruled that the language in the Settlement Agreement providing for “interest as a traditional
    mortgage note in the amount of 3.75%” was not ambiguous and, accordingly, that the trial court erred by adopting H’s calculated simple interest.
  • It also held that the trial court could not sua sponte raise the defense of laches. H had not claimed laches as a defense but rather that W’s calculation was incorrect.
  • The case was remanded so that the accrued interest owing would be calculated as it would be under a traditional mortgage note.

A Better to Way to Provide for Interest on a Divorce-Related Installment Obligation

  • The IRS has ruled that interest on an obligation between divorced spouses is “personal interest” and, hence, not deductible by the payor.
  • But, it is nonetheless taxable to the payee.
  • To avoid this tax whipsaw, the interest rate can be converted to its lower, after-tax equivalent and “baked in” to the payments.
  • For example, 2.5% is the approximate after-tax equivalent of a 3.5% pre-tax rate for an individual in a 25 percent tax bracket.
  • The first step is to calculate the payment by running an amortization schedule using the after-tax rate – 2.5% in the above example. Then provide in the divorce document for the payor to make the payments with no stated interest.
  • The use of an unstated after-tax rate avoids having the payee pay tax on interest the payor cannot deduct.
  • This is a viable approach since the IRS has stated that the imputed interest rules do not apply to divorce settlement obligations. Tech Adv Mem 200624065 (Dec 6, 2005); Priv Ltr Rul 8645082 (Aug 14, 1986).
  • Prepayment can be accommodated by providing for a discount equal to the after-tax rate applied to the remaining payments over the period they are scheduled to be paid. Here is a sample clause:

    “Plaintiff is entitled to prepay this obligation, either in full or in part, by making payments in excess of the required payments. If Plaintiff does prepay the obligation, in full or in part, [he / she] is entitled to a discount on the remaining balance of the installment payments equal to 2.5 percent of the amount prepaid for each year (prorated for a partial year) between when the prepayment is made and when such amount would otherwise be due pursuant to the terms provided above.”

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Michigan Court of Appeals Rules on Dispute on Calculation of Interest on a Divorce-Related Installment Obligation and, a Better Way to Do It. Elam v Elam, Mich App 348201 (10/15/20)”
View / Download December 2020 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “Dec 2020 : Michigan Court of Appeals Rules on Dispute on Calculation of Interest on a Divorce-Related Installment Obligation and, a Better Way to Do It. Elam v Elam, Mich App 348201 (10/15/20)”

December 2018 : Strategy for Allocating the Property Tax Deduction in Year of Divorce to Minimize Effect of New Limits on Deducting Taxes

Posted by Joseph W. Cunningham, JD, CPA

View / Download December 2018 Article – PDF File

The 2017 Tax Cuts and Jobs Act limits the annual itemized deduction for state and local taxes to $10,000. Such taxes include (1) state and local income tax, sales tax, and property tax.

The $10,000 cap does not apply to taxes on land used for farming or a rental property. It does, however, apply to second homes – e.g. a cabin up north – and to investment property.

In the year of divorce, for which each party will file a separate tax return, it is common for real property taxes to have been paid from a joint account before date of divorce. Under federal tax law, payments made from a joint account in which both spouses have an equal interest are presumed made equally by them.

That presumption can be rebutted by evidence that funding of the account was other than equal.

Example

  • Assume that H, the higher earning spouse, contributed 80% to the account and W 20%. The property tax deduction is allocated accordingly.
  • But as the higher earner, H will have higher state (and possibly local) income taxes.
  • Depending on the amount of these taxes relative to the $10,000 cap, it may be advisable to split the deduction 50:50 even though H provided substantially more funds to the account.
  • This also provides W with 50% vs. 20% of the tax deduction if she itemizes deductions on her tax return.

Observations

So, as a practical matter, the parties have some flexibility on the allocation of the property tax deduction. Factors to consider are:

  • Amount of other taxes of each party relative to the $10,000 limit.
  • Funding of the joint account from which taxes were paid prior to the divorce.
  • Whether either party will likely use the increased standard deduction.

It is often advisable to provide for the allocation in the property settlement agreement to avoid post-divorce problems at tax return preparation time.

The following summarizes some general aspects of payments of mortgage interest and property taxes in a divorce context. It is drawn from the author’s Taxation Chapter in ICLE’s Michigan Family Law.

Payments Made in a Divorce Context

The deductibility of mortgage interest, property taxes, utilities, maintenance, etc., in a divorce context depends on the following:

  • ownership of the home
  • use of the home as a personal residence
  • liability on the mortgage loan
  • whether payments are made pursuant to a qualifying divorce or separation instrument.

Ownership. While some homes may be owned individually by one of the spouses during marriage, it is more common that a marital residence is owned by the spouses as tenants by the entireties, a form of ownership that is not severable and that provides survivorship rights for each party. A tenancy by the entireties is converted to a tenancy in common incident to divorce under Michigan law unless an alternative provision is made in the governing divorce instrument. MCL 552.102. Tenants in common do not have survivorship rights but do have a severable half interest in the home. It is not unusual for one of the parties to be awarded the family residence, often the custodial parent in cases involving minor children. It is also common for such a home to be owned as tenants in common subject to sale when the youngest child reaches the age of majority or graduates from high school.

As explained below, the form of ownership may affect the deductibility of payments related to the residence.

Use of the Home as a Qualifying Residence. IRC 163(h) permits the deduction of home mortgage interest, or “qualified residence interest,” on a taxpayer’s principal residence and a second qualifying home used by the taxpayer as a residence. If a noncustodial parent vacates the family residence and lives elsewhere, he or she may select the family residence as an “other residence” provided he or she uses the home for personal purposes for at least 14 days during the year. In this regard, the use of the home by a taxpayer’s child—again, for as little as 14 days—is attributed to the taxpayer. IRC 280A(d)(1).

IRC 164(a) allows a taxpayer to deduct property taxes that he or she (1) pays and (2) is personally obligated to pay. The obligation to pay generally tracks with ownership.

Liability on the Mortgage Loan. Spouses who own their marital residence as tenants by the entireties usually have joint and several liability on the mortgage loan on which the home is pledged. It is also not uncommon for both parties to remain jointly and severally obligated on the loan after the divorce since lending institutions often will not release one party from the debt even if the other has been assigned full responsibility for its payment in the divorce settlement.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Strategy for Allocating the Property Tax Deduction in Year of Divorce to Minimize Effect of New Limits on Deducting Taxes”
View / Download December 2018 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “December 2018 : Strategy for Allocating the Property Tax Deduction in Year of Divorce to Minimize Effect of New Limits on Deducting Taxes”