Home Mortgage Interest

Down through the ages, people have devised elaborate ways to shelter themselves from the elements. To that end, we build homes which often are our largest single asset. In many divorces, the disposition of this asset becomes the primary focus. Because of that, it is important to consider the tax ramifications of a particular settlement.

One scenario we see on a regular basis is for the wife to receive exclusive use of the jointly-held personal residence with the property to be disposed of when the children reach the age of majority or the wife remarries. The proceeds are then split between the former spouses.

As part of the divorce decree or settlement agreement, it is common to see either the husband make the mortgage and tax payments or the wife make them out of the alimony paid to her. If the husband makes the payments directly, there are surprising tax implications.

Property Held Jointly as Tenants in Common Without Right of Survivorship

If the residence is held jointly as tenants in common without survivorship rights, payments made to third parties directly by the husband are to be treated as follows:

Mortgage principal and interest, insurance and taxes. 50% of the amount allocated to the payment of principal and interest on the mortgage debt and 50% of the amount allocated to property insurance and real estate taxes are each treated as alimony to the wife and includable as income by her. The husband will get a corresponding alimony deduction for this portion.

Taxes and interest. As a result of the alimony inclusion in income, the wife is entitled to a corresponding deduction for 50% of the interest payments on the mortgage and 50% of the real estate taxes associated with the residence. The husband can deduct the remaining 50% of the real estate taxes but may not be able to deduct the interest.

Utilities. When the wife is in exclusive possession of the residence, utility payments are considered alimony and are includable in the wife’s income and deductible by the husband.

Property Held as Tenants by the Entirety with Right of Survivorship

Mortgage principal, property insurance, real estate taxes and interest paid on behalf of the wife are not included as alimony when the residence is owned as tenants by the entirety with the right of survivorship. As such, the payments do not have to be included as income by the wife nor are they deductible by the husband as alimony. The only exception is if the husband agrees in a written instrument incident to the divorce to make all payments. In such case, the same rules that apply to joint tenancy without survivorship rights (discussed above) will apply.

The Other Shoe Falls

How does the husband treat the other half of the home mortgage interest which has been paid on the residence? In classic fashion, IRS publications identify this particular issue but provide little guidance. As a rule, an individual can deduct the interest if it is related to a residence. Generally, interest on a principal residence or a qualifying second home which is used as a residence is deductible assuming certain limitations are not exceeded. The dwelling that the spouse and children occupy will not qualify as a primary residence for the husband. The key question is, does it qualify as a second residence? This becomes a facts and circumstances determination. The Regulations merely refer to the use of the property as a “residence” and provide an exclusive definition when the property is rented during part of the year. This should not be an issue in most cases. If the divorcing parents are both involved in the children’s lives on an ongoing basis, or if joint custody is awarded, an argument can be made by the husband that the residence is being used as such by both parents since their children reside there. However, at present there is not a definitive answer as to whether the interest would be deductible by the husband.

Regardless of the former husband’s treatment, the wife neither receives a deduction nor recognizes income for this second half of the payment. Thus, 50% of the interest may not be deductible for either party.

A Possible Solution

One solution to ensure that the interest would be fully deductible would be for the husband to transfer his interest in the house to the wife. He could then either make payments to the wife, who would directly pay the mortgage, or pay the mortgage directly himself. In either case, the payments would be deductible by the husband as alimony and taxable to the wife. In this case, the wife would be entitled to deduct the entire amount of the interest on the mortgage and the real estate taxes. Before structuring such an arrangement, both parties would have to consider the tax implications of the split of the proceeds when the house is later sold.