Tax Planning for a Home in a Divorce
Selling in 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 exclusion.
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. 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.
When a “Nonresident Ex-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.
Specifically, the 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 privilege.
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.
Conclusion: Getting 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.