Outside of child custody and parenting plans, I know of no issue so divisive, misunderstood and mismanaged than deciding how to handle the family home in a property settlement.
Emotional attachment, personal comfort and convenience, concern for the children’s welfare and security, fear of the unknown, and perceived loss of quality of life all act to confound the already complex financial aspects of this critical decision. Too often this results in a settlement that jeopardizes the future financial security of one or both spouses. This is particularly tragic when months (or even years) later, the parties discover that while parenting plans can be adjusted post-divorce, the property settlement cannot be changed. With proper planning and preparation, such outcomes can be avoided.
The time to start preparing for the housing decision is at the beginning of the divorce, not at the settlement table. Clients need time to work through the emotional issues and collect the financial data required to make an equitable, rational decision. They need to understand there is no “magic” solution that will solve every problem, satisfy every concern, guarantee a “fair” settlement, and avoid the need to make difficult choices. Equitable distribution requires compromises. It also requires work.
I ask clients to create a housing timeline, starting when both spouses are still in the home, continuing through temporary maintenance when one or both have left the home, through the final settlement and decree, and ending at least 5 years after the divorce is final. I have them use an Integrated Divorce Process chart to identify checkpoints during the divorce where a change in housing may occur for either party. This helps establish a realistic perspective of needs that includes all housing requirements, and provides the basis for an objective analysis. The exercise also includes creating a written list of “Wants vs. Needs” to help separate emotional from objective issues and clarify priorities. These lists, like the decision itself, involve three sets of issues: Physical; Emotional; and Financial.
Separating the issues early serves several purposes. First, it helps confirm what types of professional services may be important in the case, e.g., therapists, child welfare agencies, tax specialists, real estate agents, mortgage brokers, property appraisers, financial planners, etc. Knowing this makes it easier to put the right team together, and provides a more realistic framework in which to begin estimating costs that should be included in the Financial Affidavit upon which temporary maintenance will be based. Second, specialty needs can be identified that might affect housing choices, e.g., ramps, handrails, transportation limitations, monitoring equipment, etc. Third, the financial issues become more apparent to the client, and helps focus attention on the need for comprehensive analysis of tax consequences, cash flow and net worth estimates, integrated with a complete picture of all assets and liabilities.
Establishing a realistic financial model upon which to base a housing decision requires gathering extensive data. Collecting and verifying the accuracy of this data takes time and money â€“ especially if multiple professionals are involved. But discovering during a settlement conference that a key piece of data is missing or inaccurate â€“ like the tax basis of the house â€“ can be even more time consuming and costly.
Know What is Needed
From a financial perspective, the complexity of how best to handle the house comes not from the type or amount of data needed, but from the need to run multiple “what if” scenarios that incorporate appropriate assumptions and create realistic projections. And therein lies the source of many myths and misconceptions. For example, many couples believe the tax liability of the house is simply the difference between the current market value and the mortgage value. While the outstanding mortgage is a current liability, it has nothing to do with what the IRS will consider in assessing a capital gains tax if the house is sold. This tax is determined by subtracting the tax basis of the house, (including purchase price and improvements), from the current market value.
Another misconception is what value is best to determine “current market value”. Real estate agents who provide estimates based on comparable neighborhood sales are a convenient source, and therefore often preferred by divorcing spouses. But courts often prefer the judgment of a licensed appraiser, whose services will cost the client several hundred dollars. In my experience, this is usually money well spent as it avoids subjective judgments by interested parties.
In addition to the tax basis and a mutually acceptable current market value for the house, there are a number of income and expense items that must be accurately documented. To capture this information, I work with clients to prepare three separate budgets: Historical, which is a detailed itemization of all expenses for the two to three years preceding the divorce filing; Temporary, which uses the same categories but projects anticipated expenses and income during the divorce process; and Post-Divorce, which projects these values for at least five years after the decree is issued. Using itemized worksheets based on actual credit card slips, pay stubs, check registers, statements, invoices, etc. insures that ALL costs are included.
Relying on estimates of historical spending is a sure way to underestimate future needs, and almost always results in distrust and disagreement between the parties. It is a popular but dangerous myth that estimated historical budgets are adequate for projecting future needs. Most clients readily identify large expense categories, but often overlook things like carpet cleaning, trash removal, window washing and the like. These add up over time, and when excluded from calculations of the total cost of ownership they are misleading about what a newly single client can truly afford for post-divorce housing.
While itemized budgets are essential to the housing decision, they are not the only data required. Cash flow projections are critical to show how each spouse will be impacted by various options for dealing with the house. What may seem affordable and fair immediately following the divorce may prove to be untenable several years later, particularly if a sale has tax consequences or a balloon payment is involved.
In addition to these calculations, consideration must be given to other factors. The relative value of the house should be seen as a “lifestyle” asset, not an investment asset. It is not liquid, takes time and money to sell, is subject to market fluctuations, requires capital to maintain its value, is not guaranteed to appreciate, may provide tax advantages or penalties depending on how it is handled, has emotional value (positive or negative), and affects the ownerâ€™s credit rating. Some of these factors are easily quantified. However, emotional considerations, assumptions about future market conditions, and oneâ€™s preference for liquidity and risk tolerance all are equally important, albeit subjective. As I stated earlier, there is no magic formula to incorporate these variables in a way to guarantee the outcome.
Look at All Options
Most divorcing couples tend to think there are only two or three choices about how to deal with the family home – sell it, give it to one spouse, or rent it out. In truth there are many options, with variations on these being limited only by one’s imagination, emotional state and, of course, financial reality. I suggest the following as a starting point in identifying options to handle the marital home.
Sell to a Third Party Immediately
In cases where there are few liquid assets to share, little equity in the home, and/or limited income sources, this may be the best choice. The parties share the costs and tax consequences (including the $500,000 capital gains exclusion, which may not matter if there is little equity), and there is no further involvement between the parties.
Keep the House and Buy Out the Spouse
The occupying/owner spouse bears all responsibility for cost of ownership, including costs of any future sale. Taxes will likely increase if the house appreciates in value, and keeping the house in good condition is imperative to insuring its future value. There are many variations on how the buyout occurs. One spouse may simply transfer their ownership incident to the divorce, avoiding sales costs, taxes, and granting the owner full tax basis value, in which case an offsetting transfer of other assets would occur. Or, a buyout plan involving installment payments may be negotiated, which could include future payments to the selling spouse conditional upon specified events like reselling the house, remarriage, etc. If the selling spouse intends to purchase a new home, they must be sure they can qualify for a mortgage. This should be done before any sale is executed, and the selling spouse should get a prequalification commitment letter specifying any assumptions the lender makes. If a promissory note (e.g. a divorce lien) is involved, care should be exercised to insure it meets the criteria for “commercial paper”. It is also critical that the name of the selling spouse is promptly removed from the mortgage. This option usually makes sense only when there is substantial equity in the home.
Joint Ownership Until a Specified Event or Period Elapses
Either spouse continues to occupy the home until a condition specified in the agreement occurs (e.g. children reach majority, remarriage of occupying spouse, lapse of time, etc.). Upon this condition, the parties may arrange for one to buy out the other under specified conditions, or the house is sold to a third party with specific allocation of the sales proceeds to both spouses. This is not practical in cases where spousal divisiveness would prevent cooperative ownership. There may also be issues involving how maintenance and capital expenses are paid, as well as who does the upkeep during this period. A detailed written agreement specifying who is responsible for what is essential to avoid conflicts.
Keep the House and Rent/Lease it to a Third Party
Neither spouse occupies the house and both share in pro rata fashion the proceeds from renting or leasing the house to a third party. Although rarely used, this technique may be appropriate in cases where neither spouse needs the cash from a sale, neither wants to live in the house, and the division of the future sale value of the house overrides other considerations.
Another consideration in some of these scenarios is using the existing equity to obtain a loan or second mortgage to generate short-term cash. While this is not usually appropriate, there are situations where using the technique enables one spouse to obtain career training to enhance future income if doing so does not sacrifice their long-term financial security. A more common approach is to sell the house to a third party and use the divided proceeds to allow each spouse to buy a smaller home. This is particularly effective when there is substantial equity in the family home and one partner will need a portion of the sale proceeds to fund training or career development to reenter the job market. The retraining spouse may find it is more advantageous to defer buying a new home in favor of renting while engaged in the career preparation. The short-term sacrifice often provides increased financial security when he or she reenters the job market at a higher wage. The job may also then dictate the location of a new home, avoiding untenable commuting challenges.
There are many variations on the approaches listed above. Each case requires individual analysis to identify the appropriate options. What is important is to examine ALL the options before proceeding.
Do the Math
Once the data has been collected and verified, and all the options have been identified, itâ€™s time to run the numbers. Cash flow and net worth projections should be calculated for each option. This is the only way to demonstrate objectively the result of each choice. The housing decision cannot be made in isolation – it must be integrated into a comprehensive financial model to determine the best solution. Inherent in any such model should be an analysis of whether the parties would benefit more from renting or buying a replacement house, following a sale of the family home.
These post-divorce options involve a careful comparison of tax and expense issues, as well as assessing potential opportunity costs. Renting can make sense if the money saved by avoiding a purchase is put to work in a way that provides a higher total return than if it were invested in a house. If a new house will be bought, the analysis must include a comparison of the advantages and disadvantages of using settlement proceeds to pay off the mortgage, versus various financing options. And, as I stated earlier, career needs, market conditions, risk tolerance, and children’s needs must be considered with the financial perspective.
The Bottom Line
If the foregoing sounds complicated and time consuming, it is. However, the marital home is often the largest single asset involved in dissolution. Our clients deserve to have the benefit of the best advice we can provide in helping them decide how to handle it equitably.