When a couple gets divorced, one of the biggest assets they will have to split is the marital home. But what are the tax consequences of how the home is handled?
The easiest way to dispose of the home is to sell it and split the proceeds. The IRS allows homeowners meeting certain eligibility tests to exclude from their income a certain amount of capital gains from the sale of their primary residence. This “gain” (or loss) is the selling price of the home minus any selling expenses minus any adjustments or improvements made to your home. For example, if you sold your house for $250,000, you could then deduct the cost of things like commissions, legal fees and points (expenses) as well as the amount your originally paid to purchase your home and any costs for improvements (adjustments) before potentially paying any capital gains tax. Currently, the IRS allows up to $500,000 for couples and $250,000 for individuals in capital gains exemptions.
In order to qualify for the $500,000 cap, you must file a joint tax return for the year in question AND meet the “own and use test” of the IRS. If either spouse does not meet the own and use test, then the maximum exclusion allowed would be the amount that each spouse would qualify for if treated separately.
Generally, to qualify for the maximum exemption, you must have owned the home, lived in the home and considered it to be your primary residence in at least 2 of the previous 5 years. You have three years starting from the due date of your return in the year of the sale to decide whether or not to take this exclusion.
This exemption can only be claimed once every two years, calculated from the date of the sale, unless the reason for selling a second home within a two-year period was because of health, change of employment or unforseen circumstances. In this instance, you may still be entitled to claim a reduced exemption.
What if one of the spouses has moved out during the separation? The IRS only requires one spouse to have met the own and use test for married couples who file a joint return. This means that if you are still legally married and either you or your spouse meet the 2 year requirement, then you would still qualify for the full $500,000 couples exemption on your joint return.
It is also not uncommon for one party to want to remain in the family home. If the spouse wishes this to be a permanent arrangement, they can opt to “buy out” the other spouse’s interest through a re-distribution of marital assets. In general, transfer of property between spouses is not taxed so the receiving spouse would not be taxed on their gain however, the spouse being bought out would want to make sure that their name was removed from the deed and the mortgage.
To do this, the spouse remaining in the home would typically need to refinance the property in her or her name only. Failure to do so could result in collections if the spouse remaining in the home doesn’t pay the bills. You could also face capital gains taxes if your spouse decided to sell the home years later.
Another option is to allow the spouse to remain in the home until the children are grown at which time, the house will be sold and the proceeds split among the two parties.
This is the most difficult arrangement of the three as it requires both spouses to remain on the mortgage and continue making payments on the home.
As for capital gains tax in this scenario, the IRS considered the “own and use” test to have been satisfied when you legally owned the property and your spouse continued to use the home as his or her primary residence under a divorce decree or legal separation agreement. That means that as long as your name remains on the deed and your spouse lives in the home, you would be eligible for the full capital gains tax exemption when the home was finally sold unless, of course, you had already sold a home and claimed a similar exemption in the previous two years.
To avoid any tax implications, you should discuss all your options with a tax professional.