One of the greatest assets married couples typically own is real estate -- either their own home or some kind of investment property -- and dividing property after divorce can be tricky especially if the property has appreciated since the time of purchase.
When (divorcing) clients approach us about helping to equitably distribute proceeds from the sale of a property they’ve owned, we typically see that they either want to:
- Keep the asset in one of their names, buying out the interest of the other, or
- Sell the property, take the cash proceeds, and then each be responsible for paying their share of any taxes related to the sale.
The trouble with option B is that each party is then subject to capital gains tax which can be quite costly. So, when couples seek to sell the property, and particularly when the property has appreciated greatly since the time of purchase, we tend to recommend doing an IRC Section 1031 -- a like-kind exchange -- to take advantage of the tax deferral of the gains of the real estate investment property they are seeking to sell. An IRC Section 1031 like-kind exchange lets you defer capital gains -- if you do it right.
Per IRS rules, a 1031 like-kind exchange provides an exception that allows you to postpone paying capital gains taxes if you reinvest the proceeds from the sale of an investment property (the “relinquished property”) into a similar property (the “replacement property”) as part of a qualifying like-kind exchange. The seller has 45 days to identify a replacement property and 180 days to close. There are multiple conditions on the investment property that must be met in order to be considered as a potential replacement property. For the complete list of conditions, go to www.irs.gov/pub/irs-drop/rp-02-22.pdf.
Note that gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, not tax-free.
1031 Exchanges Under Tax Reform
The Tax Cuts and Jobs Act changed many things about divorce planning, and Section 1031 is no exception.
Under the Tax Cuts and Jobs Act, IRC Section 1031 now applies only to like-kind exchanges of real property and not to exchanges of personal or intangible property.
“Effective January 1, 2018, exchanges of machinery, equipment, vehicles, artwork, collectibles, patents, and other intellectual property and intangible business assets generally do not qualify for non-recognition of gain or loss as like-kind exchanges. However, certain exchanges of mutual ditch, reservoir or irrigation stock are still eligible for non-recognition of gain or loss as like-kind exchanges.” See more here.
Reinvesting in a new property
1031 exchanges are routinely used by individuals, trusts, limited liability companies, and corporations to defer short and long-term federal and state capital gain and depreciation recapture taxes when selling and replacing real property held for productive use of a business or for investment. The 1031 exchange is viewed as providing additional working capital or an interest-free loan that would otherwise be paid as a tax. The deferred tax is due when the replacement property is sold or can be deferred indefinitely in another 1031 exchange.
Once the replacement property is held as an investment and the suggested two year hold time (“safe harbor”) is satisfied, the property can be converted to a primary residence. By converting to a primary residence a portion of the recognized gain or tax due when selling, after a minimum hold of five years with two of the three years as a primary, can be absorbed by the Section 121 $250,000/$500,000 exclusion. Depreciation recapture and aggregate time held as an investment are not eligible for the exclusion.
Safe Harbor exclusions
So what happens if a couple who recently acquired an investment rental property in a 1031 exchange and one of the two wants to occupy as their primary residence in less than the two-year holding period? Given the hold time is outside the “safe harbor” of two years, the courts apply a subjective test, “unforeseen circumstances”, as to the taxpayer’s intent at the time the replacement property was acquired. If the husband and wife can demonstrate investment intent and that conversion is occurring because of unforeseen circumstances, they should be okay.
Unforeseen circumstances can also apply to a “mixed-use” property where the taxpayer utilizes a part of the property as their primary residence and the other portion as an investment property, such as a Bed and Breakfast, farm, or a duplex. The portion used as the primary residence is eligible for the Section 121 exclusion while the portion held as an investment property is eligible for Section 1031 tax deferral. To qualify for the Section 121 exclusion, the taxpayer must hold the principal residence for periods totaling two years or more over a five year period. The exclusion is available once every two years. If the taxpayer fails to meet the two-year ownership and use requirements, then a prorated fraction of the exclusion may be taken given the unforeseen circumstances.
A few more considerations
When a spouse purchases property in a 1031 exchange, they have a lower basis (than a normal cost basis) in the property to the extent that they have deferred gains and rolled over into the new replacement property. This may be called a substituted basis or reduced basis due to the taxes that were deferred in the exchange. Some possibilities are:
- Depreciation Deductions
If, in addition to starting with a lowered basis, the spouse then took depreciation deductions for the wear, tear, and exhaustion of the property, then the remaining basis would have been further reduced each year incrementally as these depreciation deductions were taken.
- Section 1041
Years later, if the spouse gets divorced and transfers the replacement property to their ex-wife/husband (former spouse) as part of a divorce property settlement, then the former spouse will take the property with a straight carry-over basis under IRC Section 1041 (transfers of property between spouses or incident to divorce), so they get the property with a super low basis, being whatever remaining basis the transferor had left in the property. Section 1041 makes transfers between spouses tax-neutral, in that the receiving spouse just takes the transferred property subject to the other spouse's basis.
- Section 121 Exclusion
If the former spouse moves into the property and makes it their principal residence, they may be able to take a partial exclusion under IRC Section 121 once they have owned and lived in the property for two years; however, the amount of the exclusion allowed is a fraction based upon the ratio of the time the property was used as a rental and the amount of time it was used as a principal residence. Further, IRC Section 121 is inapplicable to depreciation recapture. So, the former spouse will only get to use a fraction of the principal residence as it relates to the appreciation (or natural increase in value over time), but will not be able to exclude any gains attributable to the past depreciation that was taken by either or both spouses.
- Unrecaptured Depreciation
Unrecaptured depreciation may be taxed at a maximum rate of 25% on most US real property. While normal long-term capital gains are taxed at a maximum rate of only 20%.
So, if you receive property in a divorce property settlement that was originally purchased to complete a 1031 like-kind exchange, you may be receiving the property with an unexpectedly low basis and additional potential tax complications. These tax complication may be compounded by the limitations imposed in Section 121 for the principal residence exclusion that carve-out from the exclusion the depreciation recapture
Tread carefully here. This is one area where you can lose a lot of money quickly by making the wrong decision. Be sure to converse with your BGW CPA before making any decisions regarding property in a divorce to property assess your tax consequences.