June 8, 2020
Divorcing couples sometimes wish to hold onto the family home for at least some period of time. The most common reasons are to keep continuity in the childrens’ lives or to wait for further appreciation before selling. Tax laws give them some special opportunities to avoid taxes on the eventual sale.
In general, single taxpayers can exclude $250,000 from capital gains upon the sale of their personal residence. Married filing jointly couples can exclude $500,000 from capital gains. This exclusion is allowed for one sale every 2 years. The owner(s) must have lived in the house at least 2 out of the last 5 years. (Change in place of employment, health or unforeseen circumstances allow an exception).
In the case of a divorce, the spouse who leaves the family home may still get a $250,000 exclusion from capital gains taxes. Both spouses may be able to take this exclusion even though only one of the spouses is awarded the house, and the other spouse no longer lives at the residence.
There are two special rules related to divorce:
Ownership test
Use Test
Note: If one or the other remarries prior to the sale of a home that is 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. At the end of six years, Mary will sell the home and 50% of the proceeds will be sent to John.
Mary sells the home for $750,000. Mary and John will each receive $375,000. If the basis in the property was $100,000, each has a basis of $50,000 leaving each with $325,000 gain. Each will use the $250,000 exclusion and will be taxed on $75,000 of gain.
What if, in the 2nd year after the divorce Mary marries Bill and he has lived in the house for four years before she sells it? Bill can also take an exclusion, bringing the total exclusion up to $750,000 ($250,000 for each party). This would reduce the capital gains taxes to zero for Mary and Bill (John would still owe tax on $75,000 for his half of the house).
For this to work, both Mary’s and John’s names must stay on the deed so that the IRS knows that John is entitled to his exclusion. This arrangement also has to be written in the divorce decree. (Bill gets his exclusion because he is married to Mary and has lived in the house for 2 out of the past 5 years before the sale.)
Another nice feature of the home sale exclusion is that this is not a one-time offer. It can be used again in a future home. So, each time a house is purchased and lived in for two years the exclusion will apply. With some good planning, it may be possible for a divorcing couple with a highly-appreciated home to minimize or even avoid capital gains tax.
