Planning for the Disposition of the Marital Home

BY ALVIN M. CHESLOW

A home is frequently one of the most valuable marital assets. When a marriage ends, the home is also one of the most important elements in the division of marital property The marital residence may be disposed of by a transfer between spouses or by a sale to third parties. A transfer may occur during the marriage or at the time of its dissolution, or may be deferred until a later date, such as after the emancipation of the youngest child of the marriage. The tax consequences resulting from the conveyance of the marital residence are dependent upon the identity of the transferee and (tic timing of the transfer.

Section 1041 of the Internal Revenue Code (the "Code") provides that no gain or loss is to be recognized on an interspousal transfer of property, provided that the parties are still married or, if not married, the transfer is made incident to their divorce. A transfer incident to a divorce is one that is made either within one year from the date the marriage ends or that is related to the cessation of the marriage. A transfer more than one but not more than six years after the end of a marriage may be considered related to the cessation of the marriage, and thus made incident to a divorce, if occurring pursuant to a separation instrument or divorce decree. A transfer between spouses or former spouses meeting the requirements of Section 1041 is treated as a gift. Even if one spouse buys the interest of the other or provides some other form of valuable consideration for the transfer, the gift treatment provided in Section 1041 will apply. The cost basis in the transferred property to the recipient is to be the same as the adjusted basis in the property had been to the transferor.

Transfers between former spouses that do not meet the incident to divorce criteria, and transfers to third parties are not covered by Section 1041. In those situations conveyances of the marital home will be recognized for tax purposes, subject to the provisions of Section 121 of the Code.

In 1997, Congress repealed Code Sections 1034 (rollover of gain on the sale of a principal residence) and 121 (one-time exclusion of up to $125,000 of gain on the sale of a principal residence by an individual who attained age 55) and replaced them with a new Section 121. The new law, effective May 7, 1997, provides that once every two years a taxpayer may exclude from gross income up to $250,000 of gain from the sale of a principal residence. The term "principal residence" is not defined in Section 121. However, Treasury Regulation Section 1.121-1(B) adopts a "facts and circumstances" test, meaning that if in issue, the determination of what a "principal residence" is may be decided on a case-by-case basis.

Property owners no longer need to be 55 or older to use the exclusion and may do so on multiple occasions, provided that they can satisfy certain conditions. First, an ownership and use test must be met — that is, the seller must have owned and used the home as his or her principal residence during at least two of the five years prior to the sale. The two years may be an aggregation of time periods totaling 730 days, 2 x 365, during the five-year period prior to the sale, and need not be achieved in a consecutive block of time. In addition, short temporary absences are counted as periods of use. Second, the current sale must have occurred at least two years prior to another sale in which the taxpayer would have excluded gain under Section 121. Exceptions may apply to the ownership, use and frequency of sale requirements so that an exclusion from recognition of gain may be permitted but the amount excluded may he reduced. Thus, a taxpayer who sells a principal residence after 18 months of ownership and use may exclude up to $187,500 of gain on the sale — 18/24 x $250,000, meaning that a sale at a gain of $100,000 would be completely excluded and a sale at a gain of $200,000 would produce an exclusion of $l87,500 and gain recognition of $12,500.

The gain exclusion under Section 121 increases from $250,000 to $500,000 for married taxpayers filing a joint income tax return for the year of sale, provided that (a) either spouse meets the ownership part of the ownership and use test, (b) both spouses meet the use part of the ownership and use test and (c) neither spouse is ineligible for the exclusion by reason of a sale or exchange of another residence within the prior two years. If the spouses collectively do not meet these requirements then the exclusion is determined for each spouse individually.

Two special rules are contained in Section 121 (d) for separated or divorced individuals selling the marital home. First, if the seller had become the owner of the home as a result of a Section 1041 transaction (an inter-spousal transfer), the seller's holding period, for purposes of determining whether the gain or loss would be long-or short-term, includes the period of time that the transferor spouse or former spouse had owned the property. Second, if one spouse is given the right to occupy the house pursuant to a "divorce or separation instrument," defined under Code Section 71(b) as a decree of divorce or separate maintenance, a decree requiring a spouse to pay to support or maintain the other spouse, or a written separation agreement, then the period of time that the occupant spouse uses the property as his or her principal residence is imputed to the other spouse. It should be noted that if one spouse leaves the marital home before a divorce or separation instrument is entered or executed then the period of time that a spouse occupies the marital home prior to the entry or execution of the divorce or separation instrument is not imputed to the nonoccupant spouse. Accordingly, the timing when a spouse vacates the marital home may be important for purposes of the nonrecognition provisions of section 121, depending upon the amount of time the vacating spouse had already lived in the home and how long after the entry or execution of the divorce instrument the parties intend to sell the home.

Among the specific rules included in Section 121 are that does not apply to sales by expatriates living outside of the United States, that the surviving spouse of a deceased owner of a principal residence may in certain circumstances satisfy the ownership and use requirements of Section 121 based upon the deceased spouse’s period of ownership and use, and that there is an opt-out provision. A taxpayer selling a principal residence may elect out of Section 121 by filing an income tax return for the year of sale that includes the resulting tax consequences in the taxpayer’s gross income.

The following are examples of the rules applicable to the disposition of the marital home in ease of divorce or permanent separation:

Example 1: Ike and Mamie, who are married, purchased a home six years ago for $250,000. It is currently worth $500,000. Mamie has an employer funded retirement account valued at $250,000. In addition, Ike and Mamie jointly own stock worth $250,000 but which cost them $125,000. Ike has been living separate and apart from Mamie for the past 18 months. Mamie has filed for divorce, Ike’s counsel proposes that the parties divide the marital property, with Ike to get the house and Mamie to keep the retirement plan benefit and stock. Mamie’s attorney, knowing the rules, objects to the proposal. She reminds her client of the old adage, that it is not what she gets; it is what she gets to keep. Under Ike’s proposal, upon a sale of the house at its current value he would keep the full $500,000, by reason of the $250,000 original cost basis and the $250,000 exclusion from gain under Section 121 of the Code. In contrast, although Mamie receives assets worth $500,000 before tax, upon sale of the stock and liquidation of the retirement account she would probably wind up with less than $400,000 after tax. She would be taxed for the $125,000 of profit on the stock sale at capital gain rates, short- or long-term, depending upon when they were acquired and at ordinary income rates upon liquidation of the retirement account (depending upon age and circumstances Mamie might owe an additional tax for early withdrawal). Mamie’s counsel responds to the proposal of Ike’s attorney that if the parties are to equitably distribute the marital property they must give due consideration to the after-tax value of the assets of the parties.

Example 2: Ike and Mamie’s factual circumstances are the same as set forth in example I except now Ike is the sole owner of the home and it is valued at $750,000. They permanently separate hut Mamie withdraws her complaint for divorce. The attorneys advise both parties to consider the sale of the marital home while Ike and Mamie still qualify for the $500,000 gain exclusion. They note that if the spouses continue to own the home but Ike lives elsewhere for more than three years, or if Ike and Mamie start to file separate income tax returns, they will only be entitled to a $250,000 gain exclusion upon a sale of the home. Indeed, even if Mamie eventually buys Ike out of the house, her income tax basis in the house is not increased and the exclusion from gain upon an eventual sale of the house to third parties is limited to the amount allowable for a single taxpayer.

The foregoing examples and brief overview of the law are meant to illustrate that the tax consequences of the disposition of the marital home is one of the most important matters to consider when planning for the division of marital property. Knowledge of the law is essential if the interests of the parties are truly to be protected and equitably distributed.