July 1, 2013
About a year ago our Divorce Tips highlighted the tax implications of selling the family home in a divorce, and which spouse is eligible for the $250,000 home sale exclusion. There have been many questions about how the exclusion actually works. This issue will revisit the topic in detail.
To review the Tax Relief Act 1997 (TRA ’97), the Act allows 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.
Ownership test
Use Test
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. 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, Mary’s portion of the basis is $50,000 leaving her with $325,000 gain. Even though she uses her $250,000 exclusion, she will be taxed on $75,000 of gain. John’s portion of the basis is $50,000 leaving him with $325,000 gain. Even though he uses his $250,000 exclusion, he will be taxed on $75,000 of gain.
What if, in the 2nd year, Mary marries Bill and he has lived in the house for four years before she sells it? Bill can also take an exclusion, which would reduce the capital gains taxes to zero for everyone.
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. (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.)
Question: When the house is sold, does John get part of the proceeds?
Answer: It depends on how they structured their divorce agreement. If they decided that the proceeds would be divided equally upon the sale of the house, John would get half the proceeds, Mary would get half the proceeds, and Bill would not get any of the proceeds because he was not part of the divorce agreement.
If, on the other hand, they decided that Mary would get all the proceeds, they would need to inform the title company to make out the check in just Mary’s name. John would still be able to take his $250,000 exclusion.
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.
