The COVID-19 pandemic has impacted nearly every facet of life — including our relationships. Some reports indicated the stress of the crisis, combined with people’s close and constant contact with their spouse might be to blame for some recent divorces.
A divorce is a stressful and complicated issue. The emotional toll it takes can oftentimes distract couples from the practical and legal issues that need to be considered. One of those issues is dealing with shared ownership of a home. If you’re going through a divorce, or are about to, it’s important to know the federal income tax rules that apply to a divorcing couple’s principal residence.
If you’re selling your home as part of the divorce, the federal income tax exclusion for gains from selling a principal residence can be beneficial. With proactive planning, divorcing individuals can maximize tax savings from the principal residence gain exclusion.
Under current tax law, a married joint-filing couple can exclude up to $500,000 from their income. To claim this exclusion, at least one spouse must pass the ownership test — which means you owned the property for at least two years during the five-year period ending on the sale date. Both spouses must pass the use test, which means you have used the property as your principal residence for at least two years during the same five-year period.
Selling Before the Divorce Is Final
For federal tax purposes, you are considered married for the entire year if you don’t finalize your divorce by December 31 of the year you sell your home. If that’s the case, you can shelter up to $500,000 of home sale profit in two different ways.
- 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.
- You and your soon-to-be-ex can file separate returns, and — 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
Conversely, if you’re divorced by December 31 of the year 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.
If both spouses retain partial ownership of the home in the divorce settlement, they can exclude up to $250,000 of their respective shares of the gain if 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.
There’s another possible scenario: One ex-spouse owns all or part of the marital residence but no longer lives in the home. This individual is called a nonresident ex, and they may have difficulty qualifying for the principal residence gain exclusion privilege if the home is sold several years after the divorce.
To avoid this pitfall, the nonresident ex can insist that the divorce agreement include a stipulation that they can occupy the home for a set amount of time. Once that 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.
Get It Right
Carefully worded divorce agreements are critical to qualify for the home sale gain exclusion in certain situations. Understanding federal income tax rules and proper planning before a divorce is settled can help you avoid a costly mistake.