Dear Ms. MoneyPeace: I have a question about how to calculate the cost basis of my home.
I was married when my then-husband and I bought the house I still live in. Years later, we divorced, and as part of the settlement, we had the house appraised to get the market value. I refinanced the house and paid my husband his half of the equity as part of the divorce settlement, as I wanted to stay in the house. So now, if I were to sell the house, do I base my half of the cost on the original purchase price, and the other half of the cost on the market value at the time of our divorce?
I assume I would then add the cost of any improvements. But can I add in the full cost of the improvements that were made before our divorce or would I only be allowed to add in half of those pre-divorce improvement costs? It would make sense that I would add in the full cost of improvements made after our divorce settlement.
This all seems complicated. Am I thinking about this calculation correctly?
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Given the increase in housing prices and the rate of divorce, you are not alone with this question. As a result of the pandemic, prices rose 16% from April 2020 to April 2021, the largest one-year jump in 30 years.
Divorce has three important impacts on capital gains.
1. Capital gains in divorce
Your thinking, though logical, is not the same as the tax implications from the IRS’s viewpoint. The basis is the original purchase price, plus the full cost of any improvements during your ownership years.
I consulted an expert on this.
“A divorce property settlement is different than her buying the house from someone she co-owned the home with,” says Colleen Montgomery, founder and partner at tax, accounting and business-consulting firm Montgomery & Granai in Burlington, Vermont. “Her former spouse did not recognize the sale or gains or losses for tax purposes.”
There is no change in the basis despite the market value at the time of the divorce. Property settlements for divorce are covered in detail by the IRS.
Let’s talk numbers. For example, you bought your home with your husband for $200,000 and now the house is worth $325,000. When you divorced, the house was worth $275,000. Still, the basis is $200,000, plus qualified home improvements. Once you sell your home, the sale price, less basis, will give you the gain or loss on which to calculate the capital gains tax. (So: $325,000 minus $200,000 minus improvements.) If home improvements total $60,000, then your gain will be $65,000.
2. Exclusion on capital gains
The IRS gives you an exclusion of $250,000 on any gains from home sales. (Married couples get double that.) You will qualify for this exclusion if you pass the ownership test.
The detail tax prep is best left to the experts; this background is meant to help explain the basics. Once you gather the relevant information and the details of the home improvements, you will want to contact an accountant to handle your 1040 tax filing for 2021 as it will look different than previous years.
For example, whether or not you have a tax liability due, you must report the sale to the IRS in detail. Plus, you want to be aware of your state’s rules on the sale.
3. Divorce and financial advice
Though some predicted a larger divorce rate due to the pandemic, the recent statistics for 2020 does not reflect that yet. Due in part to disruptions and court closures, last year’s divorce rate was lower following a trend over the most recent decades.
Anyone in the middle of negotiating a divorce needs to consider sharing the potential agreement with your accountant and/or financial planner. You are not alone in not having consulted a financial planner during your divorce. In the midst of the stress and emotions of a divorce, these types of details seem not worthy of note, yet are critical to women, or anyone, having solid financial footing post-divorce.
Be aware that a financial professional would have helped you consider the capital gains as an added future cost in negotiating your divorce. Facing rising legal fees, some individuals avoid this step for fear of consulting costs. Ask your divorce lawyer how she handles the financial aspects.
CD Moriarty is a certified financial planner, a columnist for MarketWatch and a personal-finance speaker. She blogs at MoneyPeace.