How To Decide Whether You Should (Or Shouldn't) Keep Your Home In A Divorce
At Johndrow Wealth Management we work with many pre and post divorcees on their financial plan, including budgeting, investment management, and planning for retirement.
Often people will come to us with a potential agreement for the division of assets which seems fair to them—for instance, one partner keeping accounts valued at $500K (split between a 401K and a non-qualified investment account) and the other partner keeping the family home, valued at $500K.
One may think, this seems fair and equal: each person gets an asset that is valued at $500K. However, we always remind people that not all assets are created equal.
In this piece we explore “the house” as an asset and whether or not you should keep your home as part of your divorce decree.
People often want to keep and remain in their home because of the emotional ties it represents. Perhaps it was the home you raised your kids in. Maybe you love your neighbors and the town you live in. Or you simply love the house itself!
The home often represents security, stability, and an extension of all your hard work. We understand these emotions and certainly don’t discount them. In this blog post, however, we explore the financial reasons to keep or not keep your home in a divorce.
Affordability of Maintaining the Home
It is one thing to keep your home in a divorce, but you have to consider how you will maintain the home.
Calculating annual home maintenance cost by percentage of its total value
A good rule of thumb is the “one percent rule.” Meaning, you should allocate about 1-percent of the purchase price of the home each year for upkeep of the home.
Using our example above, if your home is valued at $500K, you should be ready to spend approximately $5,000 on household maintenance per year.
Of course, this rule does not account for housing market fluctuations. Your home may decrease in value due to the market, but you’ll still need to continue to update it.
Calculating annual home maintenance cost by square foot
Another rule that can help you estimate the cost of household upkeep, is planning to spend $1 per square foot.
In keeping with our example above, let’s say your home has 3,000 sq. feet; therefore, you should budget $3,000 per year.
Using either rule, you need to ensure that post-divorce you have a few thousand dollars each year to keep up with your home’s maintenance needs.
Factoring in how much time you will spend on home maintenance
Beyond general home upkeep, you’ll need to consider how much work you are willing to do yourself around the home. While you were married, did you have a house cleaner? Or someone to care for your lawn and/or snow removal?
These are all expenses that need additional consideration. Can you afford to pay someone to continue to do these tasks on your new post-divorce household income? Do you have time to do them on your own?
Don’t forget the costs of renovation
Lastly, there are bigger home renovation projects to consider. Depending on their material, roofs need to be replaced anywhere from 12 years to 30 years. You may have to replace household appliances as they age, fix your HVAC system, your garage, your siding, to name a few. Your household furnishings may be to be repaired or replaced—and a big home is more expensive to furnish than a smaller home, condo, or apartment.
Property Tax & Insurance
All states have some sort of property tax, though some states have lower property tax than others. There are 24 states with home property taxes that are over 1-percent. If you’re in one of the states with 1-percent or higher property tax, your ability to pay property tax year-to-year is a significant concern.
At 1-percent property tax, you’re looking at a $5,000 bill on a $500,000 home. In 2020, New Jersey has the highest property tax at 2.44%, which means a $12,200 annual tax bill in our example. Use this link to find a full list of property taxes in the United States in 2020.
On top of property tax, we need to include homeowners insurance. According to the National Association of Insurance Commissioners, the average home owners insurance costs $1,200 per year, but of course this amount varies depending on the size of your home and the state you live in. This link provides the average annual premium for each state.
Mortgage, Utilities, etc.
At this point—using our $500K home example—we’ve determined that we’ll need approximately $11,200 per year for property tax (at 1%), home maintenance (1% value of the home) and insurance (averaging $1,200) if you decide to keep your home in a divorce. The other big factor to consider is whether the home is paid off or if you’ll continue to have to pay a monthly mortgage. Furthermore, if the home is larger in size, the utilities are going to be higher than if you decided to downsize post-divorce.
On the topic of mortgage…that is also a big factor to consider! You may think your home is worth $500K, but how large is the mortgage on the home? Is there a home equity line of credit (HELOC) taken out against the home? If your home is highly leveraged, it may not be worth to you what the market values it at.
As you can see, the costs certainly add up. After a divorce, you likely no longer have the same household income as you did pre-divorce. Even if you receive alimony that covers all these housing bills, typically alimony is not received indefinitely. In many cases, the supported spouse is expected to become self-sufficient by the courts. You must ask yourself if after alimony is reduced or ceases to exist, will you still be able to continue paying the bills?
Why Not All Assets Are Created Equal
Up until this point, we’ve discussed the possible financial challenges of keeping your home post-divorce. But let’s take this conversation a step further:
“Not all assets are created equal.”
You might wonder what this exactly means. Let’s go back to our example at the start of this blog.
Example: Sally and Joe are getting a divorce and Sally will keep $500,000 worth of accounts – $250K of her 401K and $250K of a joint non-qualified investment account. Joe will keep the family home, which is worth $500,000 according to a recent assessment. At first blush, this may seem like an equal and fair trade – each party is left with assets worth $500,000. If we think about this deeper, however, we start to see that the assets might be equal in value today, but don’t have the same worth for either party.
Liquidity
First, we consider liquidity. Liquidity is the term used to describe how easy or hard it is to sell an asset. The accounts that Sally is receiving are fairly liquid. Depending on how the accounts are invested, Sally will be able to sell the investment and receive cash for them in just a few days*.
A house, unfortunately, isn’t always as easy to sell. Even if you find a buyer right away, a typical closing doesn’t happen for a month or two. According to Zillow, in 2018 a home in the USA spent 65 to 93 days on the market, from listing to closing. If Sally needed quick access to cash, she could more easily receive it. Joe, on the other hand, would not have such accessibility owning a home.
*Liquidity is dependent on your individual investment choices. There are certainly illiquid investments as well as liquid ones. Each party should understand what is held in said accounts before making any decisions.
Potential Growth
We need to also consider the potential growth of the assets. Depending on which state you live in, your home may or may not appreciate as quickly as you’d like. According to Zillow, in 2019 the median home value in the United States increased by 3.7% over the entire year. The U.S. stock market—as measured in in our case by the S&P500—returned 30.43% in the same year (Source).
Of course, a one-year return does not mean one is a better option than the other, nor can the past return guarantee future results. This simply illustrates on how the asset appreciation can be very different. Considerations like how long you’ll remain in the home, how much updating the home needs, and housing prices in your state are very important. Similarly, understanding any costs associated with your investments are equally as important.
Taxes
Lastly, you must also consider the tax consequences of each of the assets. We already discussed property tax on a home. Sticking with our example, even when the home mortgage is completely paid in full and Joe outright owns his home, he will still need to pay his tax bill each year.
Sally on the other hand has two differing accounts. Her 401K has money invested that is growing tax-deferred. This means that Sally does not need to pay taxes on her 401K each year, until she turns 72 years old at which time she must start taking Required Minimum Distributions (RMDs). At that point, Sally will have to pay ordinary income tax on the 401K money, which is likely higher than any property tax, depending on Sally’s tax bracket at that age. That said, if Sally and Joe are currently 50 years old, this does mean that Sally does not have to pay tax on her 401K for 22 years, while Joe is paying real estate taxes that entire time.
Taxation is a different on the joint non-qualified investment account. The money added to this account is after-tax dollars. This means taxes were already paid on the money. The money is now allowed to potentially grow without needing to pay additional taxes until the investments are sold. Unlike with retirement accounts, there is never any requirement to ever use the money (no RMD). Until Sally sells the investments in this account, she will not owe taxes at all year-to-year.
Sally’s tax bill is very different from the annual tax payment that Joe owes on his home. If Sally does choose to sell any investments in this account, she would be taxed at a capital gains tax rate, which is typically lower than ordinary income tax. That said, depending on her tax bracket, this amount could be higher than Joe’s annual property tax rate.
Deciding if you should keep your home or let it go…
Overall, you can see that there are many financial considerations when determining whether to keep or sell a home in a divorce. From the cost of living and maintenance of the home to understanding the impact of the assets you’re giving up in order to keep the home, there are many factors to review with a professional.
The final thought that I’ll provide is to understand why you want to keep the home. Make a list of the emotions tying you to the home and try to think of other ways to possibly fulfill those feelings. For example, if you feel safe in your home because of its location, you can think of downsizing to a smaller gated community. Or if you are concerned about your children’s feelings, there are many ways to make a new home feel warm and exciting for them, such as bringing in elements from the old home and letting them be part of the process of buying the new home. A licensed therapist can provide many ideas!
Regardless, divorce is a complicated process and you likely need several professionals assisting you, including an attorney, financial advisor, accountant, and therapist. Don’t be afraid to ask for help. As always, Johndrow Wealth is here when you need us.
Written by Magdalena Johndrow
Maggie is a Partner and Financial Advisor at Johndrow Wealth Management. She attended Providence College and the London School of Economics prior to beginning her career on Wall Street at Barclays and JP Morgan. She has taken her experience with high net-worth clients and used it to empower families and small businesses.