How the Housing Assistance Tax Act of 1982 Continues to Impact Divorcing Spouses with Rental Properties

Discover how the Housing Assistance Tax Act of 1982 continues to impact divorcing spouses when converting a rental property to a primary residence.

Divorce brings a myriad of financial complexities, especially when it involves real estate. Among these complexities is the impact of tax legislation on property settlements and subsequent sales. The Housing Assistance Tax Act of 1982 (HATA), which includes provisions for capital gains tax exclusions and depreciation recapture, significantly affects divorcing spouses when one spouse converts an investment or rental property into their primary residence and later sells it.

This article explores how HATA applies to such scenarios, the implications for divorcing spouses, and whether the outcomes are equitable.

Overview of the Housing Assistance Tax Act of 1982

The Housing Assistance Tax Act of 1982 established guidelines for the tax treatment of capital gains and depreciation recapture on the sale of residential property. Notably, it introduced the rules governing the Section 121 exclusion, which allows homeowners to exclude up to $250,000 ($500,000 for married couples filing jointly) of capital gains from the sale of their primary residence, provided they meet certain criteria:

Ownership Test: The taxpayer must have owned the property for at least two of the five years preceding the sale.
Use Test: The property must have been used as the taxpayer’s primary residence for at least two of the five years preceding the sale.

However, HATA also contains provisions that limit the exclusion when a property has been used as an investment or rental property, referred to as "unqualified use." Additionally, depreciation claimed during the property's rental period must be recaptured upon sale, which increases the seller’s tax liability.

Scenario: Converting Rental Property to a Primary Residence

Consider this common scenario in divorce:

During the marriage, the couple owns a rental property that generates income and accumulates depreciation deductions.
As part of the divorce settlement, one spouse retains the rental property and moves in, converting it into their primary residence.
Six years later, the spouse sells the property, expecting to benefit from the Section 121 exclusion on capital gains.

Tax Implications of the Sale

The spouse selling the property faces the following tax considerations:

Partial Exclusion Due to Unqualified Use: The Section 121 exclusion is reduced proportionally based on the time the property was used as a rental (unqualified use) compared to its total ownership period.

For example:

The property was a rental for three years and a primary residence for three years, resulting in six years of total ownership.
The exclusion applies to only 50% of the capital gains because half of the ownership period involved unqualified use.

Depreciation Recapture: Any depreciation deductions taken while the property was a rental must be recaptured as taxable income, regardless of the Section 121 exclusion. This is taxed at a maximum rate of 25%, adding to the seller’s tax liability.

Is This Fair and Equitable?

From a legal and tax perspective, these rules ensure taxpayers do not disproportionately benefit from capital gains exclusions or depreciation deductions. However, the fairness of this system becomes less clear in the context of divorce.

Burden on the Spouse Retaining the Property In divorce settlements, the spouse who keeps the property often assumes full responsibility for future tax liabilities. Suppose the property has been depreciated significantly during its time as a rental. In that case, the burden of recapturing depreciation falls entirely on the selling spouse, even though both parties benefited from the deductions during the marriage. This can result in an inequitable financial outcome.
Capital Gains from Unqualified Use Limiting the Section 121 exclusion based on unqualified use disproportionately affects individuals transitioning property to a primary residence after divorce. This scenario often arises not from a desire to exploit tax benefits but as necessary during a life-changing event. Reducing the exclusion can leave the selling spouse with a significant tax bill, undermining their financial stability post-divorce.
Property Appreciation If the property appreciates significantly during the ownership period, the partial exclusion and depreciation recapture can create a substantial tax burden. This can feel inequitable, especially when the appreciation is due to market factors rather than improvements made by the spouse.

Strategies to Mitigate Tax Consequences

To address these challenges, divorcing spouses can discuss these proactive strategies with their attorney and or tax advisor:

Tax Impact Negotiation in Settlements: During divorce negotiations, spouses should account for the potential tax consequences of retaining or selling a rental property. A Certified Divorce Financial Analyst (CDFA) or tax professional can help evaluate the financial implications and structure a more equitable division of assets.
Converting the Property to a Primary Residence Early: Moving into the property as a primary residence as soon as possible can minimize the proportion of unqualified use. Although this won’t eliminate tax liabilities entirely, it can reduce them significantly.
Utilizing the Full Section 121 Exclusion: If feasible, consider selling the property sooner while the exclusion still applies to a larger percentage of the gains. Alternatively, waiting until the property meets the two-year use requirement without significant unqualified use can maximize the exclusion.

Final Thoughts

The Housing Assistance Tax Act of 1982 introduces significant tax considerations for divorcing spouses who own rental properties. While these rules ensure fair tax treatment across different property uses, their application in divorce scenarios often feels inequitable, especially when one spouse bears the full brunt of tax liabilities stemming from decisions made during the marriage.

To achieve a more equitable outcome, divorcing spouses should approach real estate settlements with a clear understanding of the tax implications. Engaging professionals, such as divorce financial analysts, tax advisors, and attorneys, can help navigate these complexities and ensure a fair division of assets and liabilities. Proactive planning and informed decision-making are key to minimizing the financial impact and securing a stable post-divorce future.

A Certified Divorce Lending Professional (CDLP®) can play an integral role in navigating these challenges. Unlike traditional mortgage professionals, a CDLP brings a deep understanding of the intersection between divorce, mortgage financing, and tax implications. By involving a CDLP early in the divorce process, spouses can benefit from strategic solutions tailored to their unique circumstances.

This is for informational purposes only and does not provide legal or tax advice. You should contact an attorney or tax professional for legal and tax advice. Interest rates and fees are only estimates provided for informational purposes and are subject to market changes. This is not a commitment to lend. Rates change daily - call for current quotations.