By Douglas Katz – 02/13/23
So you are in the midst of a divorce and you own one or more rental properties in addition to your primary home. To most people a house is a house is a house and the disposition of the additional real estate is the same as the primary home, but this could not be further from the truth. In fact, if you took the numerous challenges associated with dealing with the primary residence and multiplied it by 10, you might be close.
Dealing with a rental property during a divorce can be complex and it is important to understand the potential complexities in valuation, the complexity of dividing the asset(s) and tax implications of the sale. Here are a few key factors to consider:
- Valuation and Division of Assets
- Basis and Capital Gains Taxes
- 1031 Exchange
- Timing of the Sale
- Vesting and Borrower Entity
- Refinance Options
Valuation and Division of Assets
This consideration does touch on the previous bullet but it goes beyond as well. In a divorce, assets are often divided between the spouses, and the tax implications of the sale of a rental property must be considered in this division. If one spouse will be receiving the proceeds from the sale, they will be responsible for paying the capital gains tax on that portion of the sale and the proceeds need to be NET PROCEEDS as there are differenced between investment properties and other types, but also differenced between properties.
The other component essential to equitable division of assets is the true value of the property. Unlike a primary residence, an rental property has a valuation as sold, but also a valuation based on the income that the property generates. In many cases, it is required to apply investor models to the property to fully evaluate its true worth. There are many different ones and I recommend that divorcing clients use several to ensure any valuation is fully representative of the property. If this is more than they can handle, they absolutely need to get the help of a professional or several with different areas of expertise.
Basis and Capital Gains Tax
While the sale of a primary residence provides a capital gains exemption under many circumstances, the sale of a rental property may result in a capital gain, which is the difference between the property’s original purchase price and the sale price. Capital gains are taxed as income, and the tax rate depends on your tax bracket and the length of time you held the property.
It also depends on the basis for the property. The simple basis is the cost that you paid and that number subtracted from the sales price is your basis. This can be adjusted to account for improvements and other renovations that you have done. The true basis is the cost of the property plus the improvements, renovations, et al. This is hugely important and any seller of an investment property needs to fine tooth comb analyze their expenditures and expenses to do this right.
Even under the best of circumstances property owners can be confused by the complexity of this. In a split, it is even worse. While there are mechanisms to reduce or eliminate this, it takes time, effort and cooperation. As an example, I sold an investment property several years ago and there were hours of research needed to ensure proper documentation to adjust the basis for capital gains calculation and minimize any tax burden. This can create another thing to fight about, especially when the tax liability is determined. This should be done up as soon as possible in the process to ensure that the issue is properly addressed.
In some scenarios, divorcing couples could use a 1031 exchange for the proceeds, but the requirements are very specific and time based which, if it doesn’t sync with the divorce timeline, could result in a dead end. I discuss this at length further in the article it is so very important.
Timing of the Resolution
The timing of the sale can also impact the tax implications of the sale. If the property is sold before the divorce is finalized, it may be treated as a joint sale, and the tax implications will be divided between the spouses. If the property is sold after the divorce is finalized, it will be treated as a separate sale, and the tax implications will be assigned to the spouse who owns the property at the time of the sale.
It is recommended that individuals seek the advice of a tax professional and/or a financial advisor before making a decision about selling a rental property during a divorce. These professionals can help you understand the tax implications of the sale and develop a strategy to minimize your tax liability.
Beyond taxation, the timing of the solution the divorcing couple chooses cannot be disengaged from the larger timeline or timelines driving the divorce or that have been established as part of the marriage settlement agreement (MSA). Especially when deadlines such as those established by the legal requirements for a 1031 exchange are concerned, integration has to happen or the outcomes can be expensive and the MSA should support and not interfere a best solution.
Vesting and Borrower Entity
Vesting of an investment property is an important consideration in divorce because it determines the ownership and control of the property. When a property is vested, it means that the ownership rights are established and cannot be changed without the agreement of all parties involved. In a divorce, the vesting of an investment property can affect the distribution of assets and the division of property.
If one spouse owns the property prior to the marriage, it may be considered separate property and not subject to division in the divorce. However, if the property was acquired during the marriage, it may be considered marital property and subject to division in the divorce. In this case, the vesting of the investment property can affect the distribution of assets, as the value of the property may have changed over time and may have increased or decreased in value.
Investment properties, however, could have some other issues. Many investment properties are financed through Fannie Mae or Freddie Mac and, in those cases, the vesting for the property is very much like primary residences or second homes. They are not the ONLY provider of investment real estate funding, however. If the property was financed through private money, hard money or other unique investor programs which allow for non-individual ownership and borrowing, there can be a complex borrower and vesting arrangement. I have seen multiple level of ownership in my past experience and some even have another business entity that they own as the tenant. In these cases, the potential problems can be huge and the need for professional help can be exponential. Listen to your financial advisor and accountant as they can guide you and a trained lender with experience in divorce housing AND non-QM investment lending should be consulted too.
Suppose you do not want to sell and the intent is to retain the property to buy out the spouse. Trust me when I communicate that getting a loan during is nearly impossible and after is often difficult. Like the other considerations, this is more complex with the addition of every property especially if there is a portfolio of multiple properties. Since income is a challenge on every divorce loan, this is as important here, but unlike residential loans that have options that sometimes go up to the 50% DTI range, investment properties won’t and typically require 43% or less debt-to-income ratio to refinance. While there are some more flexible options like the ones that I addressed in the vesting section of this article, the hard money/non-QM/private money lending in not encumbered by the same ratios, but they can have other requirements like experience as a landlord and cash reserves, which need to be in compliance with guidelines. I recommend that any lender assisting you be trained lender with experience in divorce housing AND non-QM/hard money investment lending as part of their skillset to get full exposure to every possible option.
As you can see, knowledge and assistance is important for deciding on a plan for your real estate. When it comes to investment properties, it is even more essential. The financial, equity and tax implication of a mistake are huge and many times avoidable with good planning a strong divorce trained lender with experience in the investment real estate lending world for both conventional programs AND the private and had money options available to you.