05 Mar Converting Rental Property to a Primary Residence: Property Division in Divorce, Part 4
When dividing assets in divorce most people, individuals, mediators and attorneys alike, tend to focus on the property division spreadsheet. Current values of assets are listed along with outstanding debt balances that are deemed to be marital. Typically, above all else, the focus and end goal is to split property 50-50. With so much emphasis on this spreadsheet that dictates the remainder of your financial future, is there anything missing that could dramatically change your post-divorce expectations?
One of the first initial complications of divorce is altering living arrangements. Planning for this change usually creates strain on the budget and tension within how the family will operate in two homes. Divorce proceedings may have already began or the process is nearing which creates more stress and demands. Moving into a rental property that the couple owns may seem like an easy answer for solving these overwhelming living arrangement issues. However, converting rental property to a primary residence can cause significant tax complications down the road that weren’t anticipated or discussed during a dissolution of marriage. Be cautious of what might be missing!
Capital Gains Tax
Capital gains are assessed when a property is sold, whether the property is real property, a personal residence or combination as discussed in the previous article in this series, Property Division in Divorce Part 3: Home Equity (click here to read). Individuals or couples that have owned and been living in the home for two out of the last five years can offset gains by utilizing the primary home exclusion of up to $250,000 for individuals or $500,000 for married filing joint couples.
However, The Housing Assistance Tax Act of 2008 has complicated the exclusion for property that has been used as both a primary residence and a rental property. In cases where the property has been rented out after 2009, not all of the gains associated with the property can be offset with the above exclusions even if the ownership and living requirements have been met.
With the tremendous real estate growth that has been experienced in the Denver market this past decade, it is imperative to understand how much of the capital gains can be sheltered with the primary residence exclusion and if there are any amounts that will be exempt.
If the property has at anytime been rented to tenets, most likely depreciation occured. Owners depreciate assets such as rental property because it will lower income taxes and help offset rental income. Depreciation can not be offset by a primary residence capital gain exclusion which was discussed above. Therefore, any amount depreciated while holding the property will be subject to 25% depreciation recapture tax.
Making the decision of moving into a rental property that you own can be more complex then what it may seem on the surface with unique tax issues involved. The value of these properties on the property division spreadsheet may not always be of the same value down the road after taxes have been evaluated. Be sure to consider all the financial components of your divorce transition; how they affect your priorities and long-term financial situation. Financial education, analysis and proper planning before signing the final papers is more important than ever to build a strong foundation for the next chapter in life.
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