December 30, 2021
Most homeowners are aware that when they sell their
primary residence, if they sell the home for more than
they paid for it, the IRS allows some portion of the gain to
go untaxed. However, many homeowners still think that
the old “rollover rule” still applies, although this was
replaced in 1997! So, although this is old news, let’s look
at the rules that apply to real estate sales.
Under the previous “rollover rule” all the appreciation
from the sale of a primary residence was rolled over into
the new residence. Thus, there was no tax applied to the
sale of the primary residence, so long as the homeowner
had lived in it for 2 of the prior 5 years before the sale, and
the new home was purchased within 2 years of the sale.
One could keep rolling over the gain from home to home
(although not more than once every 2 years). The gain was
therefore not exempted, but rather deferred until the
homeowner sold their last house.
Under the Taxpayer Relief Act of 1997 the rollover deferral
was replaced with a tax break. The home seller can now
exclude up to $250,000 of gain for an individual taxpayer
and up to $500,000 of gain for a couple, each time the
primary residence is sold (as long as it was occupied as the
principal residence for 2 of the previous 5 years.) There is
no limit on how many times a homeowner can take
advantage of this exclusion.
As an example, John and Carol buy a house for $350,000
and get divorced the next year. Carol takes over the title
for the house. Two years after the divorce she sells the
house for $500,000. Since Carol lived in the house for two
of the previous 5 years she is entitled to a tax exclusion on
the first $250,000 of gain. Her gain is only $150,000, so
Carol pays no capital gains tax.
If a divorcing couple have lived in the home such that
there are substantial gains in the property value, it is
worth evaluating whether to sell while married to take full
advantage of the gain exclusion ($250,000 each) or (less
ideally) continue to own it jointly with a plan for selling in
the future. Even though only one of the spouses continues
to live in the house, as long as it is jointly owned they will
be able to take the joint $500,000 exclusion when sold.
Rental or investment properties are treated differently.
These types of properties are viewed the same as any
other investment holding to the IRS. A gain or loss on the
sale is subject to capital gains tax rules and is not allowed
to be rolled into the next investment property. In a
divorce where one spouse moves into a property that the
couple had owned as a rental or investment, the property
can be converted to “principal residence” status just by
living there for 2 years.
Knowing the correct tax rules that apply to real estate is
crucial in a divorce. This is especially important if the real
estate is expected to be sold in the near‐term, because the
after‐tax value of the property could be an important
