If in connection with your divorce you are going to sell the marital home, you’ll want to minimize the capital gains tax you will have to pay. This becomes an issue if your gain is going to more than $250,000.
One spouse or the other receiving the marital home in a divorce settlement is not a taxable event. The sale of the home is the event that may be taxed, depending on the amount of capital gain.
Not since 1997 have you been able to defer the capital gain on the sale of a marital home by buying another one of greater value.
However, you can exclude from federal taxation up to $500,000 in home sale capital gains if you are a married couple. You can exclude up to $250,000 if you are single. But what about divorcing couples? A tax profesional, divorce mediator or Certified Divorce Financial Analyst can help you consider your options. What are some strategies to enable a divorcing couple to minimize capital gains when the home is sold?
Capital Gains Tax Strategies
1. Sell the home before the year in which the divorce is final. For example, if the divorce is going to be final in February, sell the home before the end of the previous year. That way the IRS considers that the couple is still married at the time of the home sale and entitled to the $500,000 exclusion. The couple can file a joint tax return for the year of the home sale.
2. Sometimes in a divorce settlement, each spouse retains an ownership interest in the house. Say one spouse winds up owning a certain percentage of the home and the other spouse owns the rest. If the home is sold not too long after the divorce, each spouse can exclude up to $250,000 of their respective share of the capital gain, provided: (1) each owned their part of the home for at least two years during the five-year period ending on the sale date; and (2) each used the home as a principal residence for at least two years during that five-year period.
3. Sometimes ex-spouses continue to co-own the marital home for a more lengthy period after the divorce, even though only one of them lives there. Or one ex-spouse may have sole ownership of the home after the divorce while the other ex-spouse continues to live in it. In these situations, after three years out of the home, the ex-spouse not in the home would normally fail the two-out-of-last-five-years use test above. This would cause the nonresident ex-spouse to lose being eligible to exclude their $250,000 in gain when the house is finally sold.
Fortunately, the IRS provides a way to preserve eligibility. This is done by including certain language in the divorce decree. It should stipulate that: 1) as a condition of the divorce agreement, one spouse can continue to occupy the home as their main residence for as long as is agreed upon and 2) once this period is over, the home can either be put up for sale with the proceeds split according to the divorce agreement, or one ex-spouse can buy out the other’s share for the current market value at that time. This language in the divorce decree allows the nonresident ex-spouse to receive “credit” for the other’s continued use of the home as a principal residence. Then when the home is finally sold, the nonresident ex-spouse will qualify to exclude from taxation up to $250,000 of their capital gain. The resident ex-spouse also can exclude up to $250,000 of their capital gain.
4. Say one spouse receives sole ownership of the home in the divorce. Normally that spouse’s home sale maximum capital gain exclusion is $250,000 because he or she is now single. However, if that spouse remarries and lives in the home with the new spouse for at least two years before selling, they can qualify for the $500,000 exclusion for married couples.
5. Home sale capital gains tax rates are determined by the income(s) of the owner(s). Therefore, if the lower-earning spouse receives the house in a divorce, that spouse may pay less capital gains tax when the house is sold than if the higher-earning spouse receives it. If each spouse is to receive a portion of the home sale proceeds, the larger the percentage received by the lower-earning spouse, the lower may be the overall total capital gains tax liability.
6. Again, say one spouse receives sole ownership of the home. If that spouse can wait to sell the home in a year when his/her income is low, this will minimize the capital gains tax to be paid. If we assume an income of zero in the year of the sale, in tax year 2022 for a single person the first $41,675 of taxable capital gain is taxed at zero percent; the next $418,075 of taxable gain is taxed at 15% and any taxable gain over $459,750 is taxed at 20%.