Tax Implications of Sale of Residence Upon Divorce
For many people, the federal home sale gain exclusion is the single most valuable tax break available. But if you’re getting divorced and selling a home, you may need to plan ahead to take advantage of the tax break. We’ll explain why, but first, here’s a little background information.
Gain Exclusion Basics
If you’re unmarried, you can potentially sell a principal residence for a profit of up to $250,000
Q. If I take the exclusion of capital gain tax on the sale of my home this year, can I also take the exclusion again if I sell another home in the future?
A. Yes. With the exception of the two-year waiting period, there is no limit on the number of times you can exclude the gain on the sale of a principal residence, as long as you meet the ownership and use tests
without owing any federal tax to the U.S. Treasury. If you’re married and file jointly for the year of sale, you can potentially exclude up to $500,000 of gain. To qualify, you generally must pass both of the following tests:
1. You must have owned the property for at least two years during the five-year period ending on the sale date (referred to as the ownership test).
2. You must have used the property as a principal residence for at least two years during the same five-year period (referred to as the use test).
To be eligible for the $500,000 joint-filer exclusion, at least one spouse must pass the ownership test and both spouses must pass the use test.
If you excluded a gain from an earlier principal residence sale under these rules, you generally must wait at least two years before taking advantage of the tax break again. The $500,000 joint filer exclusion is only available when both spouses have not claimed an exclusion for an earlier sale within two years of the sale date in question.
Of course, home sales often occur in divorce situations and the cash from this tax break can come in handy.
Selling Before a Divorce is Final
Here’s how the preceding qualification rules affect homeowners getting a divorce and selling a home. Let’s say a soon-to-be-divorced couple sells their principal residence. Assume they are still legally married as of the end of the year of sale because their divorce is not yet final. In this scenario, the splitting couple can shelter up to $500,000 of home sale profit in two different ways:
First, the couple could file a joint return for the year of sale. Provided they meet the basic home sale gain exclusion timing requirements, they can claim the maximum $500,000 exclusion on their joint return.
Alternatively, the couple could file separate returns for the year of sale, using married filing separate status. Assuming the home is owned jointly as community property, each spouse can then exclude up to $250,000 of worth of gain on his or her separate return. To qualify for two separate $250,000 exclusions, the spouses must each meet the ownership test for their shares of the property and meet the use test. In most cases, the preceding favorable rules allow a divorcing couple to convert their home equity into federal-income-tax-free cash. The parties can generally divide up that cash any way they choose without any further federal tax consequences and go their separate ways.
Selling in the Year of Divorce or Later
When a couple is divorced as of the end of the year their principal residence is sold, the tax law considers them divorced for the entire year. Therefore, they are unable to file jointly for the year of sale. Of course, the same is true when the sale occurs after the year of divorce.
Let’s say you wind up with sole ownership of the residence, which was formerly owned by your ex-spouse. In this case, you are allowed to count your former spouse’s period of ownership for purposes of passing the two-out-of-five-years ownership test when you eventually sell the property. Your maximum gain exclusion will be $250,000, because you are now single. However, if you remarryand live in the home with a new spouse for at least two years before selling, you can qualify for the larger $500,000 joint return exclusion.
Now let’s say you end up owning some percentage of the home, while your ex-spouse owns the rest. When the home is later sold, both you and your ex-spouse can exclude $250,000 of your respective shares of the gain, provided that you each meet the ownership and use tests.
When a home is sold soon after a divorce, both ex-spouses typically qualify for separate $250,000 exclusions. However, when the property remains unsold for some time, the ex-spouse who no longer resides there will eventually fail the two-out-of-five-year use test and become ineligible for the gain exclusion privilege – unless certain steps are taken.
When a “Nonresident Ex-Spouse” Continues Owning a Home Long After a Divorce
In many cases, the ex-spouses continue to co-own a former marital home for a long period after the divorce. Obviously, however, only one ex-spouse continues to live in the home. The problem: After three years of being out of the house, the “nonresident ex-spouse” will fail the two-out-of-five-year use test. That means when the home is finally sold, that person’s share of the gain will be fully taxable. However, this undesirable outcome can be easily prevented with some advance planning.
Specifically, the divorce papers should stipulate that, as a condition of the divorce agreement, one ex-spouse is allowed to continue occupying the home for an agreed-upon period of time (for example, until the kids reach a certain age). At that point, the home can either be put up for sale with the proceeds split according to the divorce property settlement, or one spouse can buy out the other’s share for its current fair market value.
This arrangement allows the nonresident ex-spouse to receive “credit” for the other party’s continued use of the property as a principal residence. So when the home is finally sold, the nonresident ex-spouse still passes the use test and thereby qualifies for the $250,000 gain exclusion privilege.
The same strategy works if you are the nonresident ex-spouse and wind up withcomplete ownership of the home, while your ex-spouse continues to live there. Making your ex-spouse’s continued residence in the home a condition of the divorce agreement ensures that you (the nonresident ex-spouse) will qualify for the $250,000 gain exclusion when the home is eventually sold.
Conclusion: Getting divorced involves enough financial stress without incurring needless tax liabilities. With proper planning, you can preserve your right to take advantage of the tax-saving home sale gain exclusion privilege.
Source: TrustCounsel’s June 14, 2011 eNewsletter by BizActions.