When a couple owns real estate together and gets divorced one of three things will happen to that house.
- One party will keep the real estate and the other party will receive other marital assets have an equivalent value of their share of the house.
- One party will be awarded the real estate and then refinance the real estate to withdraw cash equivalent to the marital share of equity the other party had interest in. The cash will then be transferred to the party who does not keep the real estate.
Under both of scenarios, nothing will be owed to the IRS because the transfer was to a spouse or to a former spouse pursuant to a divorce decree.
“No gain or loss shall be recognized on a transfer of property from an individual to…a spouse, or…a former spouse, but only if the transfer is incident to the divorce.” 26 U.S. Code § 1041(a)
A clean tax-free transfer is not always possible in an Illinois divorce. Real estate can be sold and both parties can keep their respective shares of value in the real estate from the proceeds of that sale. This is often a taxable event.
Capital Gains Taxes On The Sale Of A Marital Home In Illinois
If the real estate is sold at a profit, there will be capital gains tax owed on the sale of that real estate.
If both parties file separately as the head of their own household these capital gains taxes can be significant depending on your income, the purchase price of the property, the sale price of the property and the length of ownership of the property. As of the publication of this article. the capital gains tax rate can be anywhere from 0% to 37% based on these factors.
Up to $ 500,000 of gains will not be taxed if the property was owned for more than 2 years as their primary residence.
“Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.” 26 U.S.C. Sec. 121(a)
There is a limit to the amount of tax-free gains one can receive from the sale of real estate.
“The amount of gain excluded from gross income under subsection (a) with respect to any sale or exchange shall not exceed $250,000.” 26 U.S.C. Sec. 121(b)(1)
If the sale of the real estate is made while the parties are married. The non-taxable gains shall be $ 500,000.
“In the case of a husband and wife who make a joint return for the taxable year of the sale or exchange of the property—Paragraph (1) shall be applied by substituting “$500,000” for “$250,000” 26 U.S.C. Sec. 121(b)(2)
But, if the sale of the real estate happens during the year the couple got divorced, the couple cannot file their taxes jointly.
“A husband and wife may make a single return jointly of income taxes under subtitle A, even though one of the spouses has neither gross income nor deductions” 26 U.S. Code § 6013(a)
“[A]n individual who is legally separated from his spouse under a decree of divorce or of separate maintenance shall not be considered as married” 26 U.S. Code § 6013(d)(2)
It doesn’t really matter because a separated couple can each take $ 250,000 each of tax-free gains from the sale of real estate individually (for a total of $ 500,000).
What Is A 1031 Exchange?
A 1031 exchange allows the sale of real estate which purchases other
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” 26 U.S.C. Sec. 1031(a)(1)
So, if the proceeds from real estate sold are subsequently invested in a new real estate project, there will be no capital gains tax on the sold real estates’ proceeds (up to $ 250,000 per spouse).
A 1031 exchange must be reported on IRS form 8824.
Parties to an Illinois divorce would be wise to coordinate their respective 1031 exchanges on the Marital Settlement Agreement so there is no confusion either between themselves…or the IRS.
Considerations Regarding A 1031 Exchange And Divorce
A 1031 exchange doesn’t really let you get away without paying capital gains taxes on the sale of your home. A 1031 exchange just defers the capital gains that must be paid until you can no longer use the proceeds to purchase a new home (your death, perhaps).
Capital gains is based on the sales prices less the adjusted basis of the property.
“The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis” 26 U.S.C. Sec. 1001(a)
Adjusted basis starts in determining the cost of the property when originally purchased.
“The basis of property shall be the cost of such property” 26 U.S. Code § 1012(a)
So, if you bought a house in 2010 for $ 100,000 and you sold the house pursuant to a divorce in 2020 for $ 250,000 the basis of that sale is $ 100,000.
If you kept the entirety of the sale of the house ($ 150,000) pursuant to your divorce and bought a new house with the proceeds of the sale of the old house, using a 1031 exchange your basis would be $ 100,000 from the old house NOT the $ 150,000 sale price of the new house.
So, if the new house was sold a month later for $ 150,000, there would be a $50,000 gain that may or may not be subject to capital gains…even though you sold it for no profit. The profit is determined using the original house’s original basis.
The basis of the property can then be adjusted by any number of things: improvements to the house, depreciation taken on the house (doesn’t happen with houses you live in, primarily, though), and other matters.
Because the capital gains tax you pay is a function of the basis of the property you are awarded (this is getting complicated), you must factor in the basis of the property you are awarded when you are negotiating the terms of your Illinois divorce.
Language in your Marital Settlement Agreement that can ensure the basis of the property can read as follows:
“The parties agree that subsequent to the sale of the marital home each party shall complete IRS Form 8824 reflecting a Fair market value (FMV) of other property given up of $ X and an Adjusted basis of other property given up of $ Y”
The language, of course, will be specific to the nature of the negotiated agreement.
For these reasons, it is often imperative that a Certified Public Accountant work with a divorce lawyer to ensure you are receiving assets that have the both the highest possible value and the highest possible basis in the event of the sale of those awarded assets.
Most lawyers have amazing verbal intelligence but when it comes to calculating final taxable obligations, divorce lawyers will shrug their shoulders and lament “I am bad at math.” Taxes and divorce is not rocket science. You just have to know it, keep it straight in your head and then have a Certified Public Accountant double check your work.
If you’d like to learn more about how a 1031 exchange can be used both before and after your Illinois divorce, contact my Chicago, Illinois family law firm to schedule a free consultation with an experienced Chicago divorce lawyer.