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As if the COVID-19 crisis has not done enough damage, extra stress and too much forced togetherness may be causing some married couples to call in the divorce lawyers. While marital tensions may diminish as lockdown orders are eased, a second round of stricter lockdowns may be on the way. And the kids may not be going back to school anytime soon. Not good for nerve-wracked couples who are already close to the edge.
This column covers what happens tax-wise to a divorcing couple’s principal residence, which may be one of their biggest assets. Here’s what you need to know.
Principal residence gain exclusion break can be worth big bucks
Home sales often occur during or shortly after a divorce. With real estate values still surging in some areas and holding steady in others, the federal income tax exclusion for gains from selling a principal residence can really help — especially if you’re experiencing a COVID-19-caused cash crunch.
However, divorcing individuals must plan ahead to take full advantage of the gain exclusion deal. So please keep reading.
Gain exclusion basics
An unmarried individual can sell a principal residence and exclude (pay no federal income tax on) up to $250,000 of gain. A married joint-filing couple can exclude up to $500,000. You must pass the following tests to qualify.
Ownership test: You generally must have owned the property for at least two years during the five-year period ending on the sale date.
Use test: You generally must have used the property as your principal residence for at least two years during the same five-year period.
Joint-filer test: To claim the larger $500,000 joint-filer gain exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.
You sell the home and are still married at year-end
Say you’re in the process of divorcing, and you sell your principal residence. If you’re still legally married at the end of the year of the sale (because the divorce is not yet final), you’re considered married for the entire year for federal income tax purposes. As such, you can shelter up to $500,000 of home sale profit in two different ways.
• You and your soon-to-be-ex can file jointly for the year of the sale and claim the $500,000 joint-return gain exclusion.
• Alternatively, you and your soon-to-be-ex can file separate returns. Assuming the home is owned jointly or as community property, you can exclude up to $250,000 of your share of the gain. Ditto for your soon-to-be-ex. To qualify for separate $250,000 gain exclusions, you and your soon-to-be-ex must each have: (1) owned your share of the home for at least two years during the five-year period ending on the sale date and (2) used the home as your principal residence for at least two years during that period.
You sell the home sale in year of divorce or shortly thereafter
If you’re divorced at the end of the year in which 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 with your now-ex-spouse for the year of the sale or (obviously) any later year.
• Say you wind up owning some percentage of the home. Your ex owns the rest. When the home is eventually sold, both you and your ex can exclude $250,000 of your respective shares of the gain, as long as each of you: (1) owned your part of the home for at least two years during the five-year period ending on the sale date, and (2) used the home as your principal residence for at least two years during that five-year period.
• Alternatively, say one ex-spouse winds up with sole ownership after the divorce. That person’s maximum gain exclusion is $250,000, because that person is now single. However, if that person remarries and lives in the home with the new spouse for at least two years before selling, the larger $500,000 joint-filer exclusion becomes available.
You will have continued ownership of the home long after the divorce but will no longer live there
In many cases, ex-spouses continue to co-own the former marital abode for a lengthy period after the divorce even though only one ex still lives there. Or one ex may have sole ownership of the home after the divorce while the other ex continues to live there. In these scenarios, it gets tricky for the non-resident ex (the person who still owns part or all of the home but no longer lives there) to qualify for the valuable gain exclusion privilege when the home is eventually sold.
That’s because after three years of being out of the house, the non-resident ex will fail the two-out-of-five-years use test. So if the home is sold later for a gain, the non-resident ex’s share will be fully taxable. Fortunately, this problem can be finessed with advance planning. Here’s how.
If you’ll be the non-resident ex, insist that the divorce papers stipulate that, as a condition of the divorce agreement, your ex can continue to occupy the home for as long as he or she wants, or until the kids reach a certain age, or for a specified number of years, or whatever you two can agree on. Once the magic date is reached, 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 at that time.
This stipulation in the divorce papers effectively allows you, as the non-resident ex, to receive “credit” for your ex’s continued use of the property as a principal residence. So, when the home is finally sold, you’ll pass the two-out-of-five-years use test and thereby qualify for the $250,000 gain exclusion privilege — even though you’ve not lived in the place for years, according to IRS Regulation 1.121-4(b)(2) and IRS Information Letter 2005-0055. See the following example.
Here’s an example
Chris and Pat are divorced in September of 2020. Each party retains 50% ownership of the former marital abode. As a condition of the divorce agreement, the decree stipulates that Chris can continue to reside in the home for up to six years (until her youngest child reaches age 21). Then Chris must either buy out Pat’s 50% interest (based on market value at that time) or cooperate in selling the home.
The home is sold six years later. Pat still passes the use test, even though Pat has not lived in the home for six years, because the divorce decree included the magic language (the provision permitting Chris to continue to reside in the home as a condition of the divorce agreement). So Pat passes both the use test and the ownership test when the home is sold and therefore qualifies for the $250,000 gain exclusion break. Pat can use the exclusion to shelter all or part of Pat’s share of the home sale profit. Fair enough.
Chris also qualifies for a separate $250,000 exclusion. Chris can use the exclusion to shelter all or part of Chris’s share of the home sale gain. Fair enough.
The bottom line
In the preceding example, Pat would not qualify for any home sale gain exclusion if the magic language is not included in the divorce papers. Then Pat would be taxed on Pat’s entire share of the home sale gain. Ouch! That would be a costly and easily avoided result.
However, trying to get the magic language inserted after the divorce is final may be Mission Impossible, because your ex may refuse to cooperate. So, get the magic language put in before the papers are finalized.
Finally, the sad truth is that some divorce lawyers don’t know much about the tax angles. To protect your interests, consider hiring a tax pro with heavy experience in divorce matters.
What about the vacation home?
Good question. Vacation homes are ineligible for the gain exclusion break. Only principal residences qualify. So, there are no special tax breaks if you sell a vacation home due to divorce.
While you might consider continuing to co-own a vacation home with your ex, that’s probably a bad idea for reasons that will become clear after you think about it enough. The more-realistic options are: (1) sell the place and pay the tax hit (if any) or (2) have one spouse buy out the other’s share.
If you chose the buy-out option, there are no federal tax consequences for either party if you get the buy-out done: (1) before the divorce is final or (2) within one year after the divorce is final or (3) within six years after the divorce is final and as a condition of the divorce agreement, according to IRS Temporary Regulation 1.1041-1T. All that said, getting the buy-out done sooner rather than later is good policy.
Warning: Federal-tax-free treatment for a buy-out is unavailable if your soon-to-be-ex is a non-resident alien. The buy-out could be treated as a gift or a taxable purchase/sale transaction. Consulting your tax pro is recommended if your-soon-to-be-ex is a non-resident alien.
