In many divorce cases, the major assets are real property, most often the Marital Residence. For some spouses, the divorce will include the division of a second home, rental properties, land and other real property. Dividing real property presents a number of unique challenges such as dealing with the sentimental attachment to a family home, valuing property during an economic downturn, and entity ownership.
In a typical case the division of real property begins with a valuation of the property. In uncontested cases the parties may use a service like Zillow, or look at property tax assessments to agree on a value for the property. In contested cases, or if there is commercial property or unique circumstances, it may be necessary to have a formal appraisal completed. Once there is an agreed upon value there are only a few options for disposition of the property. Either one party will keep it or it will be sold and the proceeds divided. Sometimes, as discussed later, the sale of the property may be delayed until a specified time.
One area of real property division that can easily be overlooked by the family law practitioner is the tax consequences of dividing real property. In United States v. Davis, the United States Supreme Court held that the transfer of property from a Husband to Wife in consideration for Wife’s agreement not to pursue the division of remaining assets constituted a taxable event. That meant that the spouse receiving property was forced to pay taxes on the difference between the basis at the time of the transfer and the property’s fair market value.
As a legislative response, Internal Revenue Code (I.R.C.) § 1041 was enacted. Before I.R.C. § 1041 the Code already allowed for the transfer of property between spouses free of gift taxes. I.R.C. § 1041 extended that protection to former spouses for the transfer of property incident to divorce. Specifically, I.R.C. § 1041 provides that when property is transferred between spouses or former spouses incident to divorce there is no recognized gain or loss. In other words, the spouse receiving the property as a part of the divorce retains the basis of spouse transferring their interest in the property, it carries over. This provision applies to all citizens and resident aliens and it is a mandatory tax treatment, meaning that the parties cannot agree that it will not apply.
As a simple example of how I.R.C. § 1041 works, assume a Husband and Wife have a marital residence with a tax basis of $250,000 and a fair market value (FMV) of $350,000. There is no lien connected to the property and Wife agrees to buy out Husband’s interest in the home for $175,000 (half of the FMV). Wife assumes ownership of the property and it retains the basis of $250,000. Note, during a normal transaction the tax basis would have increased to $350,000. Husband receives the lump sum payment with a tax basis of equal value. The transfer would not be a taxable event. The same rules would apply in the event of a loss. If the FMV was less than the tax basis the spouse retaining the property would be able to claim the loss upon its later sale.
A. TAX ISSUES WITH CONTINUED OWNERSHIP
1. Advantages and Disadvantages of Continued Co-ownership
Generally, when spouses are divorcing the goal is to sever as many ties between them as possible when it comes to assets/debts. Even if things are amicable at the time of separation there is no guarantee it will remain that way and the parties will likely want to move on without the need to remain in continuous contact due to ownership of an asset. However, in some situations it will be necessary for former spouses to continue to jointly own a piece of real property. This is common when there are there are minor children and the parties would like them to remain in the home and in situations where there is a weak real estate market that parties expect to improve. The advantage of joint continued ownership is that it buys time for life events (youngest child leaving for college) and market changes (a hot real estate market).
However, joint continued ownership can also present challenges. For the spouse not living in the property having the mortgage on their credit report could impact their ability to get additional credit to purchase their own property. Joint continued ownership will also keep spouses tied together because they will need to discuss things like payments for the mortgage and property taxes, maintenance, etc. Finally, there are risks related to estate planning (what if one former spouse passes during the joint continued ownership) and bankruptcy.
2. Preparing for Co-ownership
There are a few important considerations to take into account when advising a client that plans to co-own real property with a former spouse. First, ensure that all ancillary expenses associated with the home have been accounted for. The parties must contemplate who will pay for things like property taxes, the mortgage, utilities, HOA fees, etc. during the period of co-ownership. Beyond the regular recurring expenses, they must also think about who would pay for a new roof if it was needed, or other necessary repairs. The spouse remaining in the property will likely bear the burden of most expenses, but the other spouse is a retaining an interest in the property and assumingly will benefit from upkeep when the property is sold.
A second consideration is protection of the capital gains tax exclusion. This will be discussed in greater detail in the “Taxability on Sale” section of this article, but the important takeaway is that the Property Settlement Agreement or Divorce Decree must clearly state that although one spouse is leaving the residence, they are both remaining co-owners. Otherwise the spouse not living in the property will risk losing the exclusion.
Third, make sure the impact of liens attaching to the property are addressed. When the parties were married they would have owned the property in a tenancy by the entirety, however, this form of ownership is terminated when the divorce decree is entered. The property will automatically convert to a tenancy in common. During a tenancy by the entirety, the Husband and Wife both had an undivided interest in the property. For a creditor to attach a lien or judgment against the property they would have to be a creditor of both parties. In contrast, once the former spouses co-own the property by a tenancy in common a creditor of either party will be able to attach a lien or judgment against the interest in the property held by the individual party.
3. Tax Issues During Co-ownership
The main tax consideration during the period of co-ownership post-divorce is the mortgage interest deduction, which for many people is one their largest itemized tax deductions. Internal Revenue Service rules allow taxpayers to deduct mortgage interest paid on their principal residence. The deduction is not dependent on the filing status of the taxpayer.
If the parties jointly own the property post-divorce and they both contribute to the mortgage then the mortgage interest deduction may be divided. In contrast, when one spouse owns the home post-divorce only that spouse can claim the deduction. Even if the non-owning spouse continues to reside in the home, the owner spouse would claim the deduction. However, in cases where the non-owning spouse is making payments towards the property they may have tax relief options available. For example, if Husband owns the property, but Wife still makes payments towards the mortgage she would be able to deduct payments as spousal support and Husband would claim the mortgage interest deduction.
B. TAXABILITY ON SALE
1. Capital Gains Exclusion
Effective May 6, 1997, qualified taxpayers have been able to exclude gains associated with the sale of a primary residence of up to $250,000, or $500,000 if filing jointly. The residence must have been owned and used as a primary residence for two of the last five years. The use does not need to be continuous. And the exclusion can only be used once every two years. The important consideration for divorcing spouses is whether the sale of the home needs to occur before the divorce is finalized to take advantage of the $500,000 exclusion. To utilize the $500,000 exclusion: (1) the parties must file a joint tax return the year the property is sold; (2) both parties must meet the use requirements (2 of last 5 years); (3) one party owns the home; and (4) neither has used the exclusion in the last two years.
It is important to identify this distinction in cases where the sale of the marital residence will generate a gain in excess of $250,000. It may influence a spouse’s decision to sell the home and divide the proceeds rather than retain it and have a taxable gain in the future. The potential for a future taxable gain could also be weighed in the distribution of the property if a party is intent on keeping the marital residence.
As a reminder, the exclusion is only needed when the marital residence is being sold to a disinterested third party. For transfers between spouses/former spouses the exclusion would not be necessary because the taxable basis transfers with the property.
2. Taxability on Sale After Co-ownership
After the divorce both spouses would file separately in the future and therefore be ineligible for the $500,000 capital gains exclusion, meaning only the $250,000 exclusion would apply. If both spouses continued to own the home, they could each independently claim the $250,000 exclusion for their share of the home proceeds if they meet the requirements at the time of the sale. Clearly the spouse that continues to reside in the property should be eligible for the separate exclusion. For the spouse that moves out and remains a co-owner the situation is less straightforward. The use requirement continues to apply, meaning assuming they lived in the home for the two years before the divorce, they would need it to sell in the three years following the divorce. If that is unlikely, or not called for in the agreement the spouse that risks losing the exclusion may seek a credit for additional proceeds to compensate them for the discrepancy.
3. Rental, Investment, and Vacation Properties / Third Party Transfers
For properties that are not the primary residence, generally I.R.C. § 1041 protections for spouse/former spouse transfers will still apply, but capital gains exclusions will not. In other words, there should not be a taxable event when the property is transferred from one spouse to the other at the time of the divorce, but there likely will be a taxable event in the future when the property is sold. Because the capital gains exclusion does not apply to these types of properties, the tax consequences should be taken into account when they are valued.
Another issue that frequently arises with rental, investment, or vacation properties is that they are owned by a business entity created by the parties and/or they may be getting transferred to a business entity owned by one of the parties as a part of the divorce. Clearly, a client would still want to ensure that the transfer of the property falls within the confines of I.R.C. § 1041. In these situations, a transfer to a third party will still invoke I.R.C. § 1041:
a. if the transfer is required by the divorce or separation instrument;
b. if the transfer to the third party is made pursuant to the written request of the non-transferring spouse or former spouse; or
c. if the transfer is made pursuant to a written consent or notification of the transfer to the third party.
C. TRICKY ISSUES WITH TIMESHARES
Timeshares can present tricky issues because they often come with costs (maintenance fees, assessments, loan payments if there is financing) and may be viewed by the parties as more of a burden than asset. Unfortunately, they can also be difficult to get rid of and so there may not be an option to sell the timeshare as a part of the divorce. Normally, that means one spouse will be retaining ownership of the timeshare. In that situation, it is important to ensure ownership is properly transferred and that the spouse relinquishing their interest is protected from future liability.
It is important to identify where the timeshare is located and the transfer policies for the resort/timeshare corporation. Depending on where the timeshare is located transferring ownership could be as simple as executing a quit claim deed. Other states, such as Hawaii, have their own regulations for transferring title of a timeshare. Each resort will also have their own policies for transferring ownership. Many require a transfer fee and generally they will need a copy of the recorded deed.
When addressing the transfer of a timeshare in a Property Settlement Agreement, it is important to use clear language that explains the terms of transfer and who remains liable for what as far as costs and fees. The Virginia Court of Appeals dealt with this issue in Walker v. Pfeiffer. See Walker, 2000 Va. App. LEXIS 506. In Walker, the parties executed an agreement which stated that they would sell their timeshare and until it was sold Wife “agrees to save and hold harmless husband for any liability on any loan or advance of monies for the purchase or financing of the payment of the time share." There was a mortgage on the timeshare. Wife argued that the provision applied to any remaining balance on the mortgage when the timeshare was sold. Husband argued that the provision applied to mortgage payments made until the timeshare was sold. The Court held that the provision was unambiguous and agreed with Husband that Wife must reimburse him for mortgage payments pending the sale of the timeshare. Husband also filed a cross-appeal and argued that the same provision applied to annual fees associated with the timeshare. The Court disagreed on that point and found that the provision only applied to the mortgage payments. This decision illustrates the importance of ensuring that language in an agreement broadly covers any costs or fees associated with the timeshare itself and any financing associated with the timeshare.
1. Annulment Options
In cases where the marriage is void any real property owned by the parties will not be subject to Virginia’s equitable distribution statute, Virginia Code § 20-107.3. If the real property at issue is only owned by one party there are limited options available to the non-owning party, regardless of how much they contributed to the property. If the parties had a written agreement the non-owning party may have contractual remedies available.
In cases where both parties jointly owned the property, more options are available. In these situations, one party should file a partition action in the Circuit Court. See Virginia Code § 8.01-81. The partition action gives the court three options for addressing ownership of the property.
First, the court may divide the property in kind if it is of sufficient quantity and size that make the division practical. See Virginia Code § 8.01-82. In kind division of residential real estate is rare, but the court must go through the process of determining that the division “cannot be conveniently made.” See Nickels v. Nickels, 197 Va. 498 (1955).
Second, the court may allow one party to purchase the interest in the property of the other. See Virginia Code § 8.01-83.
Third, the court may order the property sold and the proceeds divided by the parties. See Virginia Code § 8.01-83. Generally, the court will appoint a Special Commissioner of Sale to coordinate the marketing and sale of the property.
2. Hybrid Property Formulas
Hybrid property is property in a divorce action that is part-separate and part-marital. In the context of real property, the common situation is when pre-marital funds are used to purchase a residence that then appreciates in value during the duration of the marriage. In Virginia, there is no required formula that a court must use to value hybrid property as long as the outcome reached by the court is equitable. See Rinaldi v. Rinaldi, 53 Va. App. 61, 669 SE2d 359 (Va. App. 2008). Two formulas, the Brandenburg Formula and the Keeling Formula are the most commonly used.
The Brandenburg Formula comes from a 1981 Kentucky divorce case, see Brandenburg v. Brandenburg, 617 SW2d 871 (Ky. App., 1981), and it was subsequently adopted by courts in Virginia, see Hart v. Hart, 27 Va. App. 46, 497 S.E. 2d 496 (Va. App., 1998), and other states. The basic formula is:
Separate Contribution / Total Contribution x Total Equity = Separate Interest
Marital Contribution / Total Contribution x Total Equity = Marital Interest
As an example, Husband and Wife buy a home immediately following their marriage for $400,000 and Husband uses his separate property to put down the $80,000 down payment. There is a mortgage of $320,000 for the remainder of the purchase price. When the parties get divorced five years later the house is worth $600,000 and the remaining principal on the mortgage is reduced to $230,000 (a reduction of $90,000). Using the Brandenburg Formula Husband’s separate interest would be $80,000 / $170,000 x $370,000 = $174,118. The marital interest would be $90,000 / $170,000 x $370,000 = $195,882. If the court evenly distributed martial property Husband would receive $272,059 (the $174,118 as his separate interest and $97,941 for his share of the marital interest) and Wife would receive $97,941. Note, the court is not required to award an equal division of the marital interest.
As recognized by the Virginia Court of Appeals, the Brandenburg Formula can produce an unfair result, particularly in a case where there is a large down payment made with separate property and a substantial mortgage coupled with a hot real estate market that leads to a significant increase in the value of the property over a short period of time. That is what led a Richmond Circuit Court Judge to apply what is known as the Keeling Formula, because it was validated by the Virginia Court of Appeals in Keeling v. Keeling. Keeling, 47 Va. App. 484, 624 S.E.2d 687 (Va. App., 2006). The Keeling Formula determines the percentage of the original purchase price that was made with separate property and then applies that same percentage to the total equity at the time of the divorce to determine the portion of the equity that is separate property with the remaining equity being classified as marital property. Using the same hypothetical values from the Branderburg Formula example, applying the Keeling Formula would lead to the following result:
Husband’s $80,000 down payment was 20% of the purchase price. The equity in the property is $370,000 ($600,000 – 230,000). Husband’s separate interest in the equity is 20% of $370,000, or $74,000. The marital interest is the remainder, or $296,000. If the court were to equally divide the marital interest then Husband would receive $222,000 ($74,000 separate interest + $148,000 for his half of marital interest) and Wife would receive $148,000.
Which formula to use? In Keeling, the Court held that there is not one formula that must be exclusively used. In fact, the trial court in that case used both formulas to value two separate properties and that was acceptable because the result was equitable.
3. Protection by Recordation
Most properties owned by married couples are held in a tenancy by the entirety. This form of ownership means that both spouses own an undivided interest in the martial property. Accordingly, a creditor must be a creditor of both Husband and Wife to attach a lien or judgment against the property while both parties are living and married.
A tenancy by the entirety terminates upon divorce and converts into a tenancy in common if both parties retain ownership of the property. Once the property is owned in a tenancy in common creditors of individual owners can attach liens or judgments against the property. Further, pre-existing recorded liens that could not previously attach, now will upon the conversion. The important point being, if title is going to be transferred as a part of the divorce, the best practice is to ensure the transfer takes place prior to the entry of the decree. If there will be a delay in transferring title the agreement (PSA) or order (Divorce Decree) can be recorded to protect the interest of the party that will be receiving title to the property.