What are the tax consequences regarding a home sale if you and your spouse split up or divorce?
The home sale exclusion remains one of the biggest and best tax breaks on the books. If a married couple filing jointly qualifies, they can exclude from tax up to a half million dollars of their profit when they sell their principal residence. However, you must meet certain requirements spelled out in the tax law. Significantly, the exclusion may be jeopardized if a couple is getting divorced.
Background: The maximum amount of the home sale exclusion is $250,000 for a single filer, or a married person filing separately, or $500,000 for a couple filing jointly. For example, say that you’re married and bought your home 20 years ago for $300,000. Currently, the home is worth $700,000. If you sell the home for $700,000, your entire $400,000 gain is excluded from tax.
Conversely, if you sell the home for $850,000 at a $550,000 profit, only $50,000 is taxable as a capital gain. The maximum tax rate on long-term capital gain (i.e., on the sale of property owned longer than one year) is 15% or 20% for certain high-income taxpayers.
However, the exclusion is not automatic. To qualify, you must have owned and used the home as your principal residence for at least two of the five years preceding the sale. It’s important to satisfy both parts of the test. Just one won’t do the trick.
These rules often trip up divorced taxpayers when an ex-spouse moves out of the home and subsequently fails the “use” part of the test. Then this spouse won’t qualify for the exclusion on their share of a sale.
Nevertheless, there is a way out. If ownership of a home is transferred to a taxpayer pursuant to a divorce proceeding, the taxpayer is treated as if they had owned the home any of the time the other spouse owned the home. So they’re not hurt by the rules.
Similarly, a taxpayer is considered to have used the home as their principal residence during any time—
The taxpayer owned the home.
The taxpayer or former spouse lived in the home under a divorce or separation agreement and used it as their principal residence.
This issue should be addressed in any divorce or separation agreement. For example, the agreement may grant an ex-spouse the right to live in the home owned by the other spouse for a specified time such as two years or until their youngest child graduates from high school. As a result, the ex-spouse’s interest is protected.
On the other side of the coin, a spouse living in the home is treated as if they own the home. So a resident spouse doesn’t have to wait at least two years until selling the home. They can sell immediately and claim the $250,000 exclusion.
In summary: The exact wording used in a legally-binding agreement can be critical. Make sure your interests are protected by your professional legal and tax advisors.
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