No, You Take the House!

Divorce, or variations on that theme, is starting to look almost as certain as death and taxes… the national average seems to be holding with about 1 out of 2 marriages ending in divorce. Among my friends, family and clients, it seems the number of couples around me calling it quits has escalated over the past few years. I suppose it could simply be my age, the circles I travel in and living in California. With splitting couples, very often their home will be their single largest asset. They may even fight tooth-and-nail to keep the home and send their “ex” packing. Here’s the thing: this could be a huge financial mistake. Often the consequences are not realized until long after signing the settlement agreement. Generally there are three issues around real estate that come up that are often overlooked in a divorce.

The first issue has to do with the property as an asset class and liquidity. Let’s say a couple (Popeye and Olive Oyl) owns a home worth $1,000,000 free & clear, i.e. no mortgage. And in addition, they have $1,000,000 of cash and invested assets. They agree to split everything 50/50. But Olive Oyl wants the home. So she will give Popeye her half of the cash in trade for his half of the house. Though Olive now has a place to live, she has 100% of her assets invested in real estate with no liquidity (unless she sells or finances some of the equity out of the property). This is equivalent to having all of your money tied up in one single, privately held investment… not real consistent with Modern Portfolio Theory.

The next issue has to do with affordability and qualifying. Let’s say Popeye and Olive have a $500,000 mortgage. The payment on the house with property taxes and insurance is $4000 per month. Olive only has to give Popeye $250,000 of her cash to buy him out. So she has $250,000 left in cash plus the house with the mortgage. The first question is can she afford the payment? That’s a much bigger question than I can address here, so let’s say she thinks she can handle the payment. But Popeye doesn’t let her get off the hook so easy. Since both signed the mortgage obligation when they were married, Popeye will remain liable from the lender’s point of view even though he may not be on the title as an owner of the property. If Olive can’t qualify on her own either for a new mortgage or in assuming the current one, Popeye may be very reluctant to go along with this.

Last, and probably one of the most overlooked issues with taking the home, has to do with . . . taxes. Popeye and Olive bought their home for $500,000 a while back. Since the value has doubled, they would have a $500,000 gain if they sold the home today. Because it was their principal residence for two out of the last five years, they would be able to exclude all $500,000 of the gain from being taxed as a married couple (see IRS Publication 936 at www.opesadvisors.com/resource/links.html). But if Olive buys out Popeye and at some point in the future she sells the home, she will only be able to exclude $250,000 of the gain as a single person. This means she will take on about a $62,000 tax burden that she will realize when she sells the home (assuming the tax laws don’t change… so could be more!). Additionally, if Olive sells the property and pays a real estate commission, she will incur 100% of that expense, as opposed to splitting it with Popeye. This could easily be another $25,000 she would have otherwise not paid (50% of a $50,000 commission). Olive has now blown about $90,000, or 12% of the assets she received out of the divorce settlement, without even knowing it.

For those of you that are able, consider working to have your marriage not be the one-out-of-two that divorce. For the other half, seek out financial, tax and legal advice prior to settling the terms of your agreement. Your attorney may be very skilled in representing you legally, but unlikely to know all of the finance and real estate consequences to your decisions.

Copyright © Jeffrey T. Smith • (415) 464-9500 • jtsmith@opesadvisors.com Jeffrey T. Smith is a financial advisor and the Marin Manager for Opes Advisors, a Wealth Management Firm specializing in Mortgage Banking and Investment Management.