January 1, 2017
I wrote about this topic 3 years ago, but receive questions about this frequently enough that I think it is worth writing about again. The tax implications of selling the family home in a divorce can be a little complicated, and timing is everything if there is a potential capital gain. Read on for a refresher on this topic.
To review, the Tax Relief Act 1997 (TRA ’97) allows a single homeowner to exclude the first $250,000 of gain in the home from capital gains tax when sold. The exclusion for a married couple is $500,000. Here then is the first timing issue: if the gain in the home is more than $250,000 the couple may want to sell the house before they divorce.
However, it is possible for both spouses to take a $250,000 exclusion even though one spouse is awarded the house and the other spouse has been out of the house for several years. To do this they must pass two tests:
Ownership test: If one spouse, pursuant to a divorce decree or separation agreement, is required to grant the other spouse the right to temporary possession of the home, but retains title to the home, and the home is later sold, the non-occupying spouse will be treated as having owned the home for the period of time that the occupying spouse owned the home as principal residence.
Use Test: In the event one spouse transfers a residence to the other pursuant to a divorce decree, the “transferring spouse” shall be able to include the “receiving spouse’s” use period in computing their own use period.
Note: If one or the other remarries prior to sale of home jointly owned with the former spouse, the remarried spouse can use the new spouse’s time in the home to meet residency requirements to use the “married filing jointly” exclusion amount.
Let’s look at an example:
John and Mary are getting divorced. Under the divorce decree, Mary is awarded the jointly owned family home for six years until their son graduates from high school. The home will remain under joint ownership and at the end of six years Mary will sell the home and give 50% of the proceeds to John.
In the sixth year Mary sells the home for $750,000. Mary and John will each receive $375,000. If the basis in the property was $100,000, Mary’s portion of the basis is $50,000 leaving her with a $325,000 gain. Mary will be able to deduct her $250,000 exclusion and will pay tax on the remaining $75,000 of gain. Because they satisfy the ownership and use tests above, John is also able to deduct $250,000 from his share of the gain – even though he hasn’t lived in the house for 6 years - so he will also pay tax on only $75,000 of gain.
For this to work, both Mary’s and John’s names have to stay on the deed so that the IRS knows that John is entitled to his exclusion. This arrangement also has to be stated in the divorce decree.
What if, in the 2nd year, Mary marries Bill? As long as John and Mary stay on the title of the house they can both take the exclusion when the house is sold. In fact since Bill lived in the house for 4 years before it is sold he can also take an exclusion, which would reduce the capital gains taxes to zero for Mary and Bill (Bill gets his exclusion because he is married to Mary and has lived in the house for at least 2 out of the past 5 years before the sale.)
Because John is still on the deed, he can show ownership and is entitled to his $250,000 exclusion. Whether or not he takes part of the proceeds does not affect his taking the exclusion.
Mary and Bill can take a $500,000 exclusion as joint owners, no matter how much Mary receives in proceeds.
Another nice feature of the new tax law is that this is not a one-time exclusion. We can use it over again every two years. So each time we buy a house and sell it after two years, we can use the exclusion.
Selling the marital home is common in a divorce, but TRA ’97 helps many couples avoid taxes due to the sale. Knowing how the rules apply in a divorce will help your clients reach a better settlement.
