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.
If you’re unmarried, you can potentially sell a principal
residence for a profit of up to $250,000
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:
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.
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.
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
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
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 remarry and 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
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 when the home is sold soon
after the divorce. 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.
“Nonresident Former 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.
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
The same strategy works if you are the nonresident
ex-spouse and wind up with complete 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.
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.