11/8/24 – Divorce, Real Estate, and Capital Gains: What Every Real Estate Agent Needs to Know

Divorce can be a tricky time for everyone involved, especially when it comes to real estate. Clients going through a divorce are often focused on emotional and logistical issues like dividing property, child custody, and figuring out who gets what. But as real estate professionals, we have to dig a little deeper. One of the biggest financial pitfalls that can hit them down the road is the tax consequences of keeping or selling the family home. And today, I want to talk about one of the most common misconceptions I've seen, and how it can turn a seemingly simple real estate transaction into a costly mistake.

The Stepped-Up Basis Myth: A Trap for Divorcees

In a typical sale of property, there's something called a stepped-up basis - which means that when someone inherits a property, the property's value is "stepped up" to its current market value, potentially reducing the taxable capital gains when it's sold. But here's the key takeaway: This doesn't apply in divorce.

I had a client recently who learned this lesson the hard way. She thought that when she divorced, the house would automatically get a stepped-up basis, which would have shielded her from a big tax hit down the line. The reality is that when assets are divided in a divorce, the property retains its original basis, meaning she'll owe capital gains tax on the appreciation since she purchased it - and it can be significant if the home has appreciated a lot over time.

Here's where things get tricky: Before her divorce, she would have been eligible for the $500K capital gains exemption (if she was filing jointly). But after the divorce? That exemption drops to just $250K for a single filer. Now, if the house appreciated by $700K and she's only exempt from $250K of the gain, she could be facing a $450K taxable gain when she eventually sells - which, depending on her tax bracket, could lead to a huge tax bill.

A Big Tax Bill = A Big Problem

This is why it's so important to address these potential issues with clients early in the process. When a divorcing client asks about keeping the home or selling it, the conversation should not just be about emotions or real estate value, but about taxes as well. Clients might assume that if they take on the property and get their "fair share" in equity, that they're walking away with the better deal. But if they don’t consider the tax liability down the line, they could be setting themselves up for a huge financial surprise.

If your client is sitting on a house that's appreciated significantly and they don't plan on selling it for a while, this tax issue could be decades in the making, but it's always better to plan ahead.

So, What Are the Options?

As real estate professionals, we know there are always options - but they require some creative thinking and a solid understanding of the client's long-term goals. Here are a few strategies to consider:

1031 Exchange (Hold and Rent the Property)

If your client can hold on to the house, one of the best strategies might be to convert the home into a rental property. After living outside the home for at least two years, they could do a 1031 Exchange, which allows them to defer the capital gains tax when they sell the property and purchase a like-kind property (such as another rental property).

This deferral can happen indefinitely, as long as they continue to exchange into new properties. It's not a way to avoid taxes forever, but it's a great way to delay that tax liability and free up some cash flow in the meantime. Of course, your client will need to be OK with being a landlord for a while!

Sell the House before the divorce is final!  

If your clients sells before the divorce is finalized then they get the full $500,000 Capital Gains Exemption and any tax hit would be shared with their soon to be Ex!

Estate Planning and Trusts

For clients with significant assets, estate planning could be the key to minimizing future taxes. By transferring ownership into a revocable living trust or other tax-advantaged vehicles, they may be able to manage their tax liability in a more efficient way. Trusts can be complicated, but for high-net-worth clients, they could be an effective solution.

Key Takeaways for Real Estate Agents

As a real estate professional, it's important to understand the tax implications of a divorce and how they can affect your client's decisions about keeping or selling the family home. Here's what you can do to help:

1. Ask the Right Questions: When working with clients going through a divorce, ask about their long-term plans for the property. Do they plan to keep it? Sell it? Rent it out? Understand their goals and connect them with a tax professional to avoid surprises.
2. Educate Your Clients: Don't assume your clients understand the tax consequences. The loss of the $500K capital gains exemption and the impact of a lower basis in the property can be a huge issue down the road. Be sure to explain this to them in terms they can understand, so they can make an informed decision.
3. Provide Options: There's never just one solution to a real estate problem. Help your clients understand all their options, including the potential for a 1031 Exchange, taking out a home equity loan, or simply selling and buying another primary residence. And don't forget about the possibility of renting out the property for a while!

Divorce is tough enough without the added burden of a big tax bill down the line. As a lender and real estate professional, I want to help you and your clients avoid these costly mistakes. So, make sure to have these conversations early, and always refer your clients to a trusted tax professional to get the best advice for their situation.

One more thing and I know I have said this before. If you die owning a property with millions of dollars in Capital Gains and you are under the $13.61 Million dollars as of 2024, then the property goes to the stepped up value and there will be no tax liability to the heirs! That amount goes up in 2025 and then sunsets in 2026 to a much lower number.

Have any questions or need more advice? You know where to find me - your favorite smartest lender! LOL!

I am available all weekend if you need anything. Let me know if you have any questions or if someone is interested in buying a property. My cell is 661-714-6258, and my office line is 661-260-2970 ext. 2222. My direct line is 661-291-2222. When you text me, please text (661-714-6258) or email me at Mike@AugustaFinancial.com.

But wait, there’s more!

Interest rates were better yesterday and are now at their best levels in two weeks. The Federal Reserve cut rates .250% yesterday as planned and rates are once again looking hopeful? Not good, but hopeful! LOL!

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Interest rates are subject to change without notice. The above are LA County Loan Limits.

Good News – We are hearing that Mariposa may be fixed, but I need all 4 insurance policies to know for sure! Anyone wanna share?  

Bad News on Condos -

Village Walk – Insurance issues - Insufficient insurance.

Diamond Head  – Insurance deductible is now $25,000 per unit which is unacceptable to the agencies

All other naughty condos have been moved to MikeMeena.com. I will post updates here, but all the information on the naughty list is on my website. Just go there and click about, and you will find our most updated list.

Please let me know if you hear anything new on condos or townhouses.

I am still available all weekend if you need anything. Let me know if you have any questions or if someone is interested in buying a property. My cell is 661-714-6258, and my office line is 661-260-2970 ext. 2222. My direct line is 661-291-2222. When you text me, please text (661-714-6258) or email me at Mike@AugustaFinancial.com.

Have a great day and an even better tomorrow. Please call me when you have a client who needs to borrow!