When a couple divorces, there are typically no tax consequences. Yet, couples may forget to consider how capital gains taxation rules apply to the sale of their home with regard to their divorce, if this is relevant. It is possible that one party will end up with a tax bill upon sale, depending how big the gain is on the home’s value and the period of ownership.
Individuals not involved in a divorce who have a gain from the sale of their main home may qualify to exclude up to $250,000 of that gain from income, according to the Internal Revenue Service. A couple may quality to exclude up to $500,000 of that gain if filing a joint return with a spouse. (See IRS Publication 523, Selling Your Home, for specific rules and worksheets.)
To qualify for either exclusion, however, individuals and couples also must meet both ownership and use tests. Generally, you are not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your current home.
Admittedly, not everyone faces taxable gains concerns due to the size of these exemptions, but a strong real estate market has produced some very large gains recently in certain Houston area neighborhoods.
Here is an actual case showing the potential tax liability for a client:
- Home sale price: $1,000,000
- Original price (adjusted): $(550,000)
- Profit: $450,000
- Exclusion: ($250,000)
- Taxable gain: $200,000
- Long term Cap. Gains @ 15% — $30,000
- Long term Cap. Gains @ 20% — $40,000
For high income earners, the 20% capital gains percentage applies. Most others pay 15%.
Factors that impact a capital gains issue include:
- What was the purchase price of the home?
- Were there any capital improvements made (other than standard maintenance like painting and repairs)?
- How long did you live in the home over the past five years?
- How long did you own the home?
- What were the net proceeds from the sale of the home?
As you can see, the purchase price of the home is only part of the “cost,” since capital improvements are added, along with commissions upon sale. Closing costs also are added to the cost basis. If the home was depreciated for tax purposes, because it was used as a rental, or part of the home was used as a home office, this would have to be deducted from the cost basis to determine the actual cost.
The owner or spouse must have owned and lived in the house for 2 of the past 5 years to meet usage and ownership requirements. Short periods spent overseas or in the hospital still count, as long as the home was considered the primary residence. The “usage” requirement can get complicated for divorcing individuals. For example, some couples separate and get back together. If they have a mediated settlement agreement, temporary orders or a divorce decree in place, the person who had to leave still qualifies for usage due to the other spouse remaining there. This could come into play if that party actually received the property during the final settlement.
Whoever receives the home in the final settlement is the party who will be responsible for any potential tax liability upon sale. Sometimes, careful planning is needed to project this.
What if the parties decide to co-own the home post-divorce until the children are out of school? Even though only one party is living there, they are both entitled to use the $250,000 exclusion. The resident parent’s usage carries over to the ex-spouse.
Note that this only works because the absent spouse still owns ½ of the home. Otherwise, the spouse remaining in the home is responsible for any taxes and has a $250,000 exclusion.
Before you make a decision about keeping a home that could result in a large capital gain, be sure to have a CPA or Certified Divorce Financial Analyst review the situation and other factors. Decisions are irrevocable once that divorce decree is signed.