What Divorcing Homeowners Need to Know

As if the COVID-19 crisis hasn’t done enough damage, some reports indicate that the extra stress and too much forced togetherness may be causing some married couples to file for divorce. This article covers the federal income tax rules that apply to a divorcing couple’s principal residence.

Gain Exclusion

Home sales often occur during or shortly after a divorce. With real estate values still surging in some areas and holding steady in others, the federal income tax exclusion for gains from selling a principal residence can be beneficial, especially if you’re short on cash during the COVID-19 crisis. Proactive planning can help divorcing individuals maximize their tax savings from the principal residence gain exclusion.

Under current tax law, an unmarried individual can sell a principal residence and exclude up to $250,000 of gain from his or her taxable income. A married joint-filing couple can exclude up to $500,000. However, homeowners must pass the two tests to qualify.

1. Ownership test. You generally must have owned the property for at least two years during the five-year period ending on the sale date.

2. Use test. You generally must have used the property as your principal residence for at least two years during the same five-year period.

To claim the larger $500,000 joint-filer gain exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.

If you can’t pass the two tests, you may be eligible for a partial gain exclusion, provided you sell your principal residence for certain reasons that are deemed to be beyond your control. Examples include a job change or health issues.

Before the Divorce Is Final

Some couples decide to sell their principal residence while they’re in the process of getting divorced. If you’re still legally married on December 31 of the year the deal closes — because the divorce hasn’t yet been finalized — you’re considered married for the entire year for federal income tax purposes. In this scenario, you can shelter up to $500,000 of home sale profit in two different ways.

1. You and your soon-to-be-ex can file a joint tax return for the year of the sale and claim the $500,000 joint-return gain exclusion.

2. You and your soon-to-be-ex can file separate returns. Assuming the home is owned jointly or as community property, you can both exclude up to $250,000 of your share of the gain. To qualify for separate $250,000 gain exclusions, each spouse must pass the ownership and use tests.

Selling within Two Years after the Divorce

Alternatively, if you’re divorced at the end of the year in which you sell your principal residence, you’re considered divorced for that entire year for federal income tax purposes. So, you can’t file a joint return with your ex-spouse for the year of the sale or any later year.

If both spouses retain partial ownership of the home in the divorce settlement, what happens when you sell the home? In that year, both spouses can exclude up to $250,000 of your respective shares of the gain if you both pass the ownership and use tests.

Alternatively, if only one spouse winds up with sole ownership after the divorce, that person’s maximum gain exclusion is $250,000, because he or she is now single. However, if that person remarries and lives in the home with the new spouse for at least two years before selling, the larger $500,000 joint-filer exclusion becomes available.

Nonresident Ex-Spouses

There’s another possible scenario: One ex-spouse owns all or part of the marital residence but no longer lives in the home. Here, the nonresident ex (the person who still owns part or all of the home but no longer lives there) may have difficulty qualifying for the principal residence gain exclusion privilege when the home is eventually sold — if the sale happens several years after the divorce is final.

Why? After being out of the house for at least three years, the nonresident ex will fail the use test. So, if the home is sold later for a gain, the nonresident ex’s share will be fully taxable.

To sidestep this pitfall, the nonresident ex can insist that the divorce papers stipulate that, as a condition of the divorce agreement, the ex-spouse can continue to occupy the home for as long as he or she wants, until the kids reach a certain age or for a specified number of years. Once that prescribed time frame expires, the home can either be put up for sale with the proceeds split according to the divorce agreement, or one ex can buy out the other’s share for current market value.

This stipulation in the divorce papers effectively allows the nonresident ex to receive “credit” for his or her ex spouse’s continued use of the property as a principal residence. So, when the home is finally sold, the nonresident spouse will pass the ownership and use tests, thereby qualifying for the $250,000 gain exclusion privilege — without living there.

Case in Point

To illustrate how this works, consider Terry and Taylor who finalized their divorce in August 2020. Each spouse retains 50% ownership of the former marital home. Their divorce decree stipulates that Terry can continue to reside in the home for up to six years (until Terry’s youngest child reaches age 21). Then Terry must either buy out Taylor’s 50% interest (based on market value at that time) or cooperate in selling the home.

The home sells six years later. Taylor still passes the use test, even though he hasn’t lived in the home for six years, because the divorce decree included a provision permitting Terry to continue to reside in the home as a condition of the divorce agreement. So, Taylor passes both the ownership and use tests when the home is sold. Therefore, he qualifies for the $250,000 gain exclusion break. He can use the exclusion to shelter all or part of his share of the home sale profit.

Terry also qualifies for a separate $250,000 exclusion. She can use the exclusion to shelter all or part of her share of the home sale gain.

Get It Right

Carefully worded divorce agreements are critical to qualify for the home sale gain exclusion in certain situations. A keen understanding of the federal income tax rules and proper planning before the papers are finalized can help soon-to-be-ex-spouses avoid costly mistakes. Contact your tax advisor for more information.

What About the Vacation Home?

Only principal residences qualify for the home sale gain exclusion break. So, there are no special tax breaks if you sell a vacation home before or after a divorce.

While you might consider co-owning a vacation home with your ex, that option may not be realistic for many divorcing spouses. Other options are:

• Selling the home and paying the tax hit (if any), or
• Having one spouse buy out the other’s share.

If you chose the buy-out option, there are no federal tax consequences for either party if you get the buyout done:

• Before the divorce is final,
• Within one year after the divorce is final, or
• Within six years after the divorce is final and as a condition of the divorce agreement.

In most cases, it’s better for everyone to execute the buyout sooner, rather than later.

Important: Federal-tax-free treatment for a vacation home buyout is unavailable if your soon-to-be-ex is a nonresident alien. The buyout could be treated for tax purposes as a gift or a taxable purchase/sale transaction. Consult your tax advisor if this is your situation.