October 1, 2016
After being involved with many divorce cases I find that the one issue often overlooked by attorneys is the cost basis in the house. This number is very important – it can turn an asset into a liability. Here’s an example:
Jason and Heidi are divorcing after having been married for 18 years. They are working with their attorneys to decide how to divide their assets equally. Those assets are a marital residence worth $650,000, an IRA worth $250,000 and a savings account worth $450,000. The $450,000 in the savings account represents an equity loan taken against the house.
Jason proposed to Heidi that she take the house and sell it (she can’t afford the upkeep). She would net $200,000. And she should also take the IRA worth $250,000. He would take the savings account and they would each end up with $450,000.
His proposal looked like this:
Assets Heidi Jason
House $650,000
- 450,000
Net Equity $200,000 $200,000
IRA $250,000 $250,000
Savings $450,000 $450,000
Total $900,000 $450,000 $450,000
Heidi talked this over with her attorney and they thought that this sounded fair. However, the attorney forgot to ask “What is the cost basis in the house?”
What Heidi’s attorney forgot to ask would have revealed that Jason had paid $90,000 for the house 17 years earlier. That means there will be a $560,000 gain. The IRS allows single filers to keep the first $250,000 of gain tax-free, but any gain above that is taxed as a capital gain. Heidi received $200,000 (after paying off the equity loan) but had to pay a 15% long-term capital gains tax, costing her $46,500 (($560,000 - $250,000) x 15%), so she had only $153,500 left.
The $250,000 that Jason borrowed from the house and put in the savings account was his, tax-free and clear. So in after-tax terms this is what the split really looked like:
Assets Heidi Jason
Net Equity in House $200,000
Less tax - 46,500
Balance $153,000 $153,500
IRA $250,000 $250,000
Savings $450,000
Total $403,500 $450,000
He ends up with $450,000 and she ends up with $403,500, because the question was not asked about the cost basis.
One solution is to sell the house before they divorce, allowing Jason and Heidi, as married filers, to keep the first $500,000 of gain tax-free. That would have reduced the taxable gain to $60,000 and the tax owed to $9,000. The net proceeds after tax of $191,000 - $28,000 more than what is available if Heidi sells the house after the divorce - could then be factored into the equitable division of assets.
Be sure to investigate the cost basis in all assets. Then there will be no surprises.
