It is a common occurrence for divorcing couples to sell their homes. This move not only provides both parties with a fresh start post-divorce but also releases funds to divide the marital estate. If you find yourself in this situation and your primary residence has significantly appreciated during your ownership, it is crucial not to miss out on the home sale gain exclusion. This tax benefit can result in substantial savings. However, timing is of the essence.
Essentials of the Home Sale Gain Exclusion To qualify for the home sale gain exclusion, you need to meet two criteria:
- Ownership: You should have owned the home for a minimum of two years during the five-year period leading up to the sale date.
- Use: The home must have been your principal residence for at least two years during the five-year period leading up to the sale date.
While still married, on a joint tax return, you can exclude up to $500,000 of gain from the sale of a principal residence if one spouse meets the ownership test and both spouses meet the use test. Special considerations come into play after a divorce. It’s important to note that the ownership and use tests are entirely independent, so the periods of ownership and use do not need to overlap. For these tests, two years means a total of 24 months or 730 days. Additionally, to qualify for the home sale gain exclusion, you must pass the anti-recycling test, which means you cannot have excluded a previous gain within the two years leading up to the date of the later sale. Essentially, you cannot recycle the gain exclusion privilege until two years have passed since its last use. As a married individual, you can only claim the larger $500,000 exclusion for joint filers if neither you nor your spouse utilized the gain exclusion for a prior sale within the two years. An unmarried person can potentially exclude up to $250,000 of gain on the sale of their principal residence from federal income tax. However, for a married couple, the home sale gain exclusion can be worth twice as much under certain conditions. Here’s what divorcing couples should be aware of to maximize this valuable benefit.
Selling While Still Married
If you and your soon-to-be-ex-spouse sell your principal residence a year before the divorce is finalized, the IRS will still consider you married for that year for federal income tax purposes. Despite being considered married for tax purposes, you can potentially exclude up to $500,000 of home sale gain in two ways: File a joint tax return for the year of sale, where you can claim the larger $500,000 joint-filer exclusion if you meet the ownership and use tests. File separate returns for the year of sale using the married-filing-separate status. If the home is jointly owned or considered community property, each spouse can exclude up to $250,000 of their share of the gain, provided both meet the ownership and use tests. In many cases, these rules enable divorcing couples to convert their home equity into cash without incurring federal income tax on the transaction.
Selling in the Year of Divorce or Later
If a couple gets divorced at the end of the year in which their principal residence is sold, they are considered divorced for the entire year for federal income tax purposes and cannot file jointly for the year of sale. The same applies when the sale occurs after the year of divorce. Whether you can claim the home sale gain exclusion in these situations depends on the circumstances. For example, if Andy is awarded sole ownership of a home previously owned by his ex-spouse Briana under the terms of their divorce agreement, Andy can count Briana’s ownership period to satisfy the two-out-of-five-years ownership test when he eventually sells the property. As a single individual, Andy’s maximum gain exclusion will be $250,000. However, if he remarries and lives in the home with his new spouse for at least two years before selling, he can qualify for the larger $500,000 joint-filer exclusion. Bill and Sandy have a different scenario. As per their divorce agreement, both retained a percentage ownership of the home. When the home is sold later, both can exclude $250,000 of their respective shares of the gain, provided they each meet the ownership and use tests.
Post-Divorce Ownership
In some cases, ex-spouses continue to co-own the former marital residence for an extended period after finalizing their divorce. After three years of being out of the home, the “nonresident ex” will fail the two-out-of-five-year use test. Consequently, when the home is eventually sold, that person’s share of any gain will be fully taxable. Nonresident ex-spouses can retain their gain exclusion privilege by specifying in their divorce agreements that their ex-spouses can continue to occupy the home for a certain period. This arrangement allows nonresident exes to receive “credit” for their former spouse’s continued use of the property as a principal residence. Consequently, when the home is sold, the proceeds can be split per the divorce agreement, or one ex-spouse can buy out the other’s share.
Exceptional Gains
If you have a gain on the sale of your home that exceeds the allowable exclusion, the excess gain is a long-term gain if you’ve owned the property for over one year. The current maximum federal rate on long-term gains is 20%, but most people won’t owe more than 15%. However, you might also owe the federal 3.8% net investment income tax (NIIT) on the taxable portion of your gain, and you might owe state income tax, too.
For More Information
While home prices have cooled off in many areas, your home may still be worth a lot more than you paid for it. If so, the principal residence gain exclusion break can be a big tax saver, especially for soon-to-be-divorced couples who are considering selling homes they owned while married. Contact your tax advisor to determine the optimal tax treatment for your situation.
