picture showing how a 1031 works

When a couple who own a home together decides to get a divorce, one of the biggest decisions they will have to make is what to do with the marital home. One option that may be available to them is a 1031 exchange.

This is a process where the owner of a property can sell it and use the proceeds to buy another property. In this blog post, we will discuss what a 1031 exchange in divorce is, how it works, and the benefits and risks associated with using it. We will also provide tips on how to complete a 1031 exchange in divorce.

What is a 1031 Exchange in Divorce

A 1031 exchange is a process that allows you to trade one property for another without having to pay capital gains tax on the sale. This can be especially beneficial in a divorce, where property division can be a complex and contentious issue. Or if the divorcing couple have owned the home for less than 2 years.

By 1031 exchanging Properties, you and your spouse can each walk away with the property you want without incurring any tax liability. This can help to simplify the divorce process and give you both a clean slate to start your new lives.

If you are considering a 1031 exchange in your divorce, it is important to consult with a qualified tax professional to ensure that it is the right decision for your situation.

How Does a 1031 Exchange Work in Divorce

A 1031 exchange can be a helpful tool in divorce proceedings, allowing couples to defer capital gains taxes on the sale of property. In order to qualify for a 1031 exchange, the couple must agree to sell the property and reinvest the proceeds into another property.

The new property must be of equal or greater value than the original property, and it must be held for investment purposes. 1031 exchanges can be complex, so it is important to consult with a tax professional before proceeding.

However, for couples who are able to successfully navigate the process, a 1031 exchange can provide significant tax savings.

The Benefits of Using a 1031 Exchange in Divorce

A 1031 exchange can be a valuable tool in divorce situations. By using a 1031 exchange, spouses can exchange property without incurring any capital gains taxes.

This can be a particularly useful strategy for high-asset divorces, where the capital gains taxes on the sale of property could be significant.

In addition, a 1031 exchange can help to simplify the division of assets in a divorce. Rather than selling property and dividing the proceeds, spouses can simply exchange property with each other. This can help to avoid difficult negotiations and reduce the overall stress of the divorce process.

For these reasons, 1031 exchanges are worth considering for couples who are going through a divorce.

The Risks of Using a 1031 Exchange in Divorce

1031 exchanges have become a popular tool for investors looking to defer capital gains taxes on the sale of investment property. However, 1031 exchanges can also be used in divorce situations, where one spouse wants to keep the property and the other spouse wants to sell.

While 1031 exchanges can be a helpful way to keep property in the family, there are also some risks to consider. If the property is sold in a 1031 exchange, the proceeds from the sale must be reinvested in another property within a certain timeframe.

If the couple divorces before the reinvestment period is up, one spouse may be forced to sell the property at a loss in order to comply with the 1031 exchange rules.

graph showing Central Ohio home appreciation last 4 yearsThis issue could be particularly true in today's real estate market with homes appreciating at astounding rates. Homes here in Central Ohio have seen an increase in home appreciation by 35% in the last 4 years and had an average of 12.1% in 2021 alone.

 

The average American home owner currently has over $57,000 in home equity, according to CoreLogic's 3rd Quarter of 2021 home study, which could create a push by the "out-spouse" to sell their marital home and can cash in on their home equity.

Here is the chart showing the current average home equity in 2021.

CoreLogic chart showing home equity

When is the best time to use a 1031 Exchange in Divorce

One of the most important financial decisions you can make during a divorce is whether or not to use a 1031 exchange. This tool allows you to defer capital gains taxes on the sale of your home, which can be especially helpful if you are looking to buy a new property after the divorce.

However, there are some important factors to consider before making this decision.

  • First of all, you will need to have an agreement in place with your ex-spouse in order to qualify for the 1031 exchange.
  • Secondly, both you and your spouse must be on good terms with each other in order to complete the transaction.
  • Finally, it is important to consult with a financial advisor to ensure that a 1031 exchange is the best option for your situation.

How to complete a 1031 Exchange in Divorce

There are a few things to keep in mind when completing a 1031 exchange in divorce.

  • First, both parties must agree to the exchange.
  • Second, the properties being exchanged must be of equal or greater value.
  • And finally, the 1031 exchange must be completed within six months of the divorce being finalized.

1031 Exchanges and Titling

In many instances, real estate is the single-largest jointly owned asset in a marriage. Couples who acquired investment properties during their marriage face some additional hurdles when trying to split assets, but they can be overcome with careful execution from qualified tax professionals.

Titling is one of the main challenges associated with divvying real property acquired in a 1031 exchange. In order to comply with IRS regulations, the same taxpaying entity must be listed on the title of the replacement asset.

So a couple that acquired a vacation rental during their marriage can’t simply sell the asset and complete another exchange without holding joint title -- not an ideal situation for couples trying to separate their lives and key financial assets.

However, under section 1041 of the IRS Code, one spouse can make a tax-free transfer of their ownership interests in real property to the other. So in theory, one spouse can transfer his or her shares, and the sole owner can then divest the asset and complete a 1031 exchange, if desired, to defer capital gains.

Many tax professionals find this issue a little murky, with very little direct guidance from the IRS on the matter. Proceed down this path under the guidance of legal and financial advisors with direct experience in separating 1031 exchange properties in a divorce to avoid a disqualified exchange.

1031 Exchange and Adjusted Basis

If one spouse does transfer their interests in an investment property to the other, they do so at an adjusted basis under IRC Section 1041. 

This carryover basis rule applies regardless of whether there’s gain or loss in the value of the asset. For example, a couple purchases a vacation rental for $100,000. During divorce proceedings, the husband transfers the property to the wife for $180,000, the property’s current fair market value. The wife’s adjusted basis in the asset remains $100,000

1031 Exchange: Occupying an Investment Property

In some instances, couples acquire investment properties through a 1031 exchange, and one party wants to occupy the residence after splitting up. Tax professionals counsel a two-year minimum hold time for properties acquired during a 1031 exchange to satisfy the requirement that the property was purchased primarily for business use or as an investment.

If that safe-harbor hold time has not been met, an audit may disqualify the previous 1031 exchange and leave the ex-spouses with a capital gains obligation.

Talk to a CDLP as Soon as Possible

Speaking to a Certified Divorce Lending Professional to discuss your options to purchase and/or refinancing an investment property during the divorce process can make all the difference in the world in your 1031 Exchange.

As a rule of thumb, you should always work with a Certified Divorce Lending Professional as well as a CDRE (Certified Divorce Real Estate Expert) when going through a divorce and real estate or mortgage financing is present.

Bottom Line

A 1031 exchange in divorce can be a helpful way for couples to get a fresh start. However, there are some risks associated with using this process, so it is important to understand how it works and what the potential consequences could be before making a decision.

If you are considering a 1031 exchange in divorce, our team can help you navigate the process and make sure you are aware of all your options.