Property that appreciates over time may have what is often referred to as a built-in tax gain. What is a built in tax gain? It is the capital gain a taxpayer will generate as a result of selling the property after the divorce and after the tax exclusion outlined below.
Said differently, if you “keep the home” as part of your settlement you not only receive a piece of real estate you also receive a future tax liability that you will have to pay to the government. So, you have to be careful how you handle your settlement structure.
If the real estate you purchased has appreciated over time and is higher than the amount of the tax exclusion (currently $500,000 for couples filing married filing jointly and $250,000 for taxpayers filing married filing separately, head of household or single) then the property will have what is commonly referred to as a built-in tax gain.
Let’s say Spouse 1 ends up with the piece of real estate as part of the settlement structure. At a future point in time Spouse 1 decides to sell the real estate. What will Spouse 1 experience as a result of not incorporating the built-in tax gain into Spouse 1’s settlement structure? Spouse 1 will have to pay tax on the appreciated value that exceeds $250,000. This assumes Spouse 1 has not remarried. Otherwise the tax exclusion would be $500,000.
To provide further context, let’s say the piece of real estate in question is Spouse 1’s primary residence. Let’s also say the primary residence is valued at $1,000,000 as of the settlement date. Spouse 1 and Spouse 2 purchased the primary residence for $300,000 a number of years ago and made no improvements to the property.
Now, let’s say Spouse 1 sells the property within 3 years of the settlement date for $1,200,000. If you subtract the $1,200,000 (current value of real estate) from $300,000 (purchase price) the gain on the sale would equal $900,000. If you subtract $250,000 (tax exclusion for unmarried taxpayers) from the $900,000 you end up with $650,000 in capital gains. The current federal capital gains tax rate is 15%. When you multiply $650,000 by 15% you discover you have a federal tax liability of $97,500 that you have to pay the government during the year the property is sold.
After the sale is completed you might ask yourself why wasn’t your ex-spouse responsible for part of these tax obligations. When your financial settlement structure was designed you thought you were getting more money from your divorce in terms of real estate than what you actually ended up receiving in your pocket. Yet the fact that you sold the property for a gain over and above the tax exclusion forced you to pay federal taxes on the gain on sale of real estate. If we incorporated state taxes the situation would only look worse.
You have now pre-experienced the implications of not addressing the built-in tax gain into your settlement structure. How should you do this differently to manage your financial risks? Let’s take the $1,000,000 valuation of the primary residence as of the settlement date. Let’s subtract $300,000 (purchase price) and $250,000 (tax exclusion) from that amount. This results in $450,000 of built-in tax gain. The $450,000 represents 69% ($450,000/$650,000) of the total built-in tax gain that both spouses were mutually responsible for as of the settlement date. This built-in tax gain needs to be incorporated into the settlement structure to manage each party’s risk. 69% of $97,500 (the federal tax liability from the gain on sale) translates into $67,103 of shared tax liability. 50% of this liability translates into $33,551 of money that you unknowingly left on the table as a result of not incorporating your built-in tax gain into your settlement structure.
It is important to note when you get a divorce the tax gain exclusion noted above automatically decreases by $250,000. Why? If you were married the $500,000 tax exclusion applies. Yet, if you get a divorce you may only receive a $250,000 tax exclusion as a result of having a different tax filing status (i.e. head of household or filing as single). $500,000 less $250,000 equals a $250,000 decrease in the tax gain exclusion. Said differently, a decrease in the tax exclusion translates into you owing more taxes to the government.
If your divorce is relatively amicable and you are considering selling your real estate you should evaluate whether to sell the property before the divorce is finalized to simply gain the tax benefit of filing as married filing jointly and receiving the benefit of the full $500,000 tax exclusion.
Every divorce has a number of factors that hide in the data. Financial specialization in divorces is critical to manage your financial risks before your divorce is finalized. These issues have to be extracted and properly addressed in the settlement structure. This relatively simple situation cost this divorcing party over $33,551. This could have been avoided if the risk was uncovered and properly included in the settlement structure.
About the Author
Larry Smith is a Founding Partner of Divorce Outcomes, a specialized professional services firm that manages all of the financial aspects in a divorce process. Since 2003 he has worked as a trusted financial advisor, financial advocate, divorce architect and technical financial expert; he is not an attorney. He is an alumni of KPMG and Andersen with expertise in technical accounting, forensics, sophisticated taxation, management consulting, risk management, advanced process engineering, business combinations, divorce management, multi-party negotiations, advanced quality analytics and cognitive performance technologies. Since 1986 Larry has been advising individuals and organizations about innovative financial solutions to resolve complex financial challenges that arise in life and in business.
For both personal and business divorces, Larry is considered an expert in divorce strategies, divorce process management, financial divorce architecture, financial risk management, taxation for divorces, financial divorce forensics, advanced divorce analytics, financial divorce negotiations and mediation, business valuations and sophisticated equity structures. He helps clients shape complex financial decisions, manage communication risks and ever-changing negotiating positions to strategically preserve or grow wealth from these types of transactions.
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About Divorce Outcomes
Divorce Outcomes is a specialty services firm that helps people both domestically and internationally manage all of the financial decisions that arise in their divorce process. We are not attorneys. We are financial experts who partner with our clients as their personal financial advocates. We help our clients manage their divorce process, uncover hidden financial risks, architect divorce solutions, manage ever-changing negotiating positions, communicate complex financial matters and close the divorce process as soon as possible with a goal to arrive at the best outcomes possible. Throughout the process we evaluate the current state of our clients’ financial lives with an objective to best reposition their future. We do not sell any products. We simply raise issues that are in our clients best interest. Our clients share with us we:
- unfold, analyze and repackage their financial life so they are well positioned after their divorce
- preserve the value of their business or marital estate
- continuously strive to provide a return on our services
- build balanced financial solutions grounded in evidence
- find ways to make our client, and at times both parties, money through the process
- design their divorce to work for them and their family’s life
- provide mental clarity to make decisions
- reduce the total process time from start to close
- minimize the stress and unpleasant memories that can last a lifetime
As we reach an agreed upon settlement structure, we help our clients identify a fitting attorney who can leverage the financial solution to draft and record the requisite legal documents. Where outcomes are at risk from a traditional process, we function as expert financial negotiators or financial mediators to turn around the situation and achieve our client’s desired outcomes.
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute formal advice or a recommended course of action as every person’s situation is unique and different. The information here is not intended to be, and should not be, relied upon by the recipient to make a decision without professional guidance.