In many divorce cases, real estate assets are among the most valuable at issue, whether they are limited to the couple’s principal home or include investment property. Numerous factors come into play when determining how such assets will be divided. Read on to learn about some of the most critical real estate assets.

Marital vs. Nonmarital Property

In many states, only marital property is subject to division in divorce proceedings. Nonmarital property is treated as the sole property of the respective spouse.

Marital property generally refers to property acquired during the marriage. Nonmarital property typically includes property one spouse brought into the marriage and kept in their name — but the laws vary by state (a prenuptial or postnuptial agreement could potentially designate property as non-marital, too).

In Illinois, for example, nonmarital property also includes:

• Property a spouse inherited during marriage;
• Property acquired in exchange for other nonmarital property;
• Appreciation on nonmarital property (subject to a right of reimbursement if it is commingled with marital assets); and
• Certain other types of property.¹

The Relevant Property Distribution Law

States either apply community property rules or equitable distribution rules for divorce purposes. Community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. In the absence of a prenuptial agreement, assets are typically divided equally in community property states. All other states follow equitable distribution rules.

One example of how equitable distribution rules are applied is in Illinois, which requires that marital assets be divided “without regard to marital misconduct in just proportions considering all relevant factors”.²

It is important to realize that “equitable” does not necessarily translate to “equal” or a 50/50 split. Courts in these states vary on how they divide property, but some things they may consider are:

• The spouses’ contributions to the acquisition of the property;
• The duration of the marriage;
• Alimony agreements;
• Prenuptial or postnuptial agreements;
• The spouses’ relative economic circumstances;
• The spouses’ ages, health, occupation, amount and source of income, employability, debts and needs; and
• Child custody arrangements.

Some courts consider the tax consequences as well, but the spouses may be wise to retain their own tax experts, as tax rules are complex.

Potential Options

Real estate assets often end up being sold in a divorce, either to a third party (with the net proceeds divided between the spouses) or by one spouse buying out the other. Buyouts come with risks, though. For example, the purchasing spouse assumes the risk that the property could depreciate. Conversely, the selling spouse could lose out on appreciation.

Co-owning the property (as, for example, tenants in common) is another option, but that can create a range of complications, financial and otherwise. For example, the ex-spouses will each remain jointly liable on the mortgage. Additionally, they will need to agree on who can claim the mortgage interest and real estate deductions.

Don’t Forget the Tax Consequences

While transfers of property between spouses that are “incident to divorce” do not result in taxable gain or loss,³ limitations apply. Transfers must:

1) Occur within one year after the date of the divorce; or

2) Be related to the cessation of the marriage.

A transfer is related to the cessation of the marriage if it is part of a divorce or separation agreement and occurs within six years after the divorce date.

Note that the spouse who receives the property also receives the carryover basis in the property,⁴ so the tax liability is deferred. As a result, the property’s value can end up being less than it appears.

That is not the only potential tax implication to weigh when dividing real estate assets. For example, a custodial parent may be allowed to stay in the principal residence for a certain number of years, with the property then sold. But that arrangement could result in taxable capital gains that may not have resulted if the home were sold while the spouses were still married and filing jointly.

The division of rental properties could affect the application of passive-activity rules. The spouse who receives such a property may no longer satisfy material participation requirements, for example. In addition, any suspended losses are added to that spouse’s basis, and the transferring spouse is not allowed any future deductions for them.⁵ Other tax carryforwards — including capital losses, net operating losses, excess business losses, business tax credits, qualified business losses and investment interest expense — also could be impacted.

Related Read: Divorcing? Don’t Let Your Estate Plan Fall Through the Cracks

Conclusion

There are many things to consider with divorces that may not be obvious. A detailed analysis of immediate and future years’ taxes can help you make informed decisions and give you an idea of what to expect.

This blog is intended for information only and should not be considered legal advice. If you desire legal or tax advice for a particular situation, you should consult with your advisor. For more information, please contact Joshua Goldschmidt at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.

[1] 750 ILCS § 5/503 (a)(1-8)

[2] 750 ILCS § 5/503 (c)(2)(B)(d)

[3] IRC §1041(a)

[4] IRC§1041(b)(1-2)

[5] IRC§469(j)(6)(A-B)