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April 19, 2024 Tax

The Favorable Interest Rate Mortgage as Marital Asset

By: Erin A. Simmons

Pre-pandemic, it was not uncommon to draft settlement agreements where one spouse would buy-out the other’s interest in a marital residence, typically with a provision requiring the spouse retaining the residence to refinance or pay off the existing mortgage within an agreed-upon period of time.  But with prevailing interest rates on 30-year fixed mortgages topping 7%, it is worth considering whether a favorable interest rate mortgage could be leveraged as an asset itself in furtherance of a marital settlement agreement.

As a threshold issue, divorce attorneys must assess and advise their clients whether it is economically feasible for the client to retain the marital residence – often an emotional issue rooted in a desire to maintain stability for the family in the face of a divorce but not always practical for a variety of reasons.

Even if there are sufficient assets in the marital estate to allow for one spouse to buy-out the other’s interest in the residence, the costs of refinancing may prove to be an impediment in the current interest climate for the spouse retaining the residence – as well as potentially implicating support needs if the cost of the monthly mortgage increases substantially.

Take for example the monthly cost of a $300k mortgage on a residence pre-pandemic and post-pandemic:

Monthly Cost of a $300k 30-Year Fixed Mortgage (Principal + Interest Only)*
Pre-Pandemic (3%)** $1,265
Post-Pandemic (7%)*** $1,995

*According to a Mortgage Bankers Association of American press release dated January 31, 2024: “The average loan size for purchase applications has picked up in recent weeks to $444,100, the largest average loan size since May 2022.”

**The 30-year fixed rate mortgage average in the United States on March 5, 2020 was 3.29%.

**The 30-year fixed rate mortgage average in the United States on October 26, 2023 was 7.79%.

This represents a 57% increase on the cost of the principal and interest alone – before the payment of property taxes and homeowner’s insurance, which have also seen significant increases post-pandemic due in part to inflationary factors.

It is also possible that the spouse retaining the marital residence may not qualify for a refinance for any number of reasons: insufficient income, too much debt, poor credit history.  ASeptember 2023 report by the Consumer Financial Protection Bureau found that “denial rates for refinance applications were higher than those for home purchase loans.  The overall denial rate on applications for refinance loans was 24.7 percent in 2022, a steep increase from 14.2 percent in 2021 and 13.2 percent in 2020.”

In this more challenging economic climate, it is worth considering whether a favorable interest rate mortgage could be used to craft a win-win outcome for divorcing parties.  But how can the favorable interest rate mortgage be used in this manner and what considerations must the family law practitioner bear in mind when negotiating such a deal? 

Timeframe for the Arrangement

If divorcing parties agree that a non-retaining spouse will remain on an existing favorable interest rate mortgage for economic reasons (i.e., maintaining the lower monthly mortgage payment) or because the retaining spouse cannot qualify for a refinance, counsel should set a predictable timeframe for which this arrangement will last.   The parties could agree to a fixed amount of time (e.g., 5 years), or they could connect this period to an anticipated event (e.g., a child’s graduation from high school) – at which point the retaining spouse would either refinance the mortgage or list the marital residence for sale.

To this end, it is important to consider whether the non-retaining spouse’s interest will be bought out at the time of the settlement, or at the point at which the retaining spouse either refinances the mortgage or lists the property for sale.  The decisions regarding how and when the buy-out will occur will have implications on other considerations raised herein including how tax benefits are shared (or not) and how risk is addressed.  

Tax Considerations

IRS Publication 936 addresses the deduction of home mortgage interest and explains that a taxpayer may deduct home mortgage interest on the first $750,000 ($375,000 if married filing separately) of indebtedness.  The parties’ filing status depends on whether the divorce was finalized on or before December 31 of the filing year.   

IRS Publication 504 describes rules for divorced or separated individuals noting specifically that that if the taxpayer paid mortgage interest “on a qualified home [see IRS Publication 936] held as tenant by the entirety” then the taxpayer can deduct “the mortgage interest you alone paid” on a separate married filing separate federal return.  The IRS notes that these rules do not apply in community property states.

If the residence continues to be jointly owned following a divorce, the parties can share the mortgage interest deduction reflected in Form 1098.  If the residence is transferred to the name of only one spouse, however, only that spouse may take the mortgage interest deduction. 

A tax advisor should be consulted in the course of drafting the marital settlement agreement to ensure the agreement addresses how tax issues are handled during and after the divorce process.

Risks to the Non-Retaining Spouse

If representing the non-retaining spouse in this scenario, it is essential that the family law attorney consider potential risks to the non-retaining spouse who has agreed to remain on the mortgage.

For example, the non-retaining spouse may discover when they attempt to take out a mortgage for a new residence that their borrowing ability is impeded as a direct consequence of remaining on the mortgage for the marital residence.  The representing attorney should advise the client of this potential and discuss the client’s future intentions with respect to a home purchase.

The non-retaining spouse must also consider the possibility of damage or destruction of the marital residence for which the non-retaining spouse is still liable for if they remain on the mortgage.  While most lenders will require homeowner’s insurance to cover at least the cost of the outstanding mortgage, it may make sense for the parties to carry a higher level of coverage to address unexpected losses.  The settlement agreement should be drafted to address who is responsible for carrying the homeowners’ insurance, what the disclosure requirements are for the coverage, and how insurance proceeds will be distributed in the event of an unexpected loss.

Finally, the non-retaining spouse should be protected from the possibility that the retaining spouse does not pay the mortgage debt – in which case the mortgage company would still seek to recover from the non-retaining spouse.  The settlement agreement should clearly state that if the retaining spouse fails to make the monthly mortgage payment on time, the residence will be listed for sale.

Given the potential complexities of this unconventional arrangement, the family law attorney is well-served to assess and advise the client in consultation with tax, finance, and real estate professionals who can advise on options available to divorcing parties to leverage the favorable-interest mortgage as an asset.

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    Erin A. Simmons

    Esq. New York, NY

    Vice-Chair, ABA Section of Family Law Taxation Committee