Two tax rules to know if you are divorcing and keeping the house
Tim and Sheila married after a whirlwind courtship. When they divorce, Sheila gets the home and decides to sell it a short time later. Sheila worries she won’t meet the ownership criteria to exclude some of the gain on the sale. Fortunately for Sheila, there are special tax rules for divorced homeowners.
Recently on the blog, we took a close look at IRC Section 121, the tax rules that govern the sale of a principal residence. In a nutshell, these rules allow some taxpayers who sell their home to exclude a portion of the gain from capital gains tax. If your home has appreciated significantly since you bought it, and you decide to sell it, Section 121 may allow you to reduce your tax bill.
About Section 121 of the tax code
Section 121 states that a single taxpayer can exclude up to $250,000 of gain on the sale of their principal residence. Married couples can exclude up to $500,000. To qualify for the exclusion, certain criteria must be met:
Either spouse has owned the principal residence for two of the last five years (the “ownership test”).
Both spouses have used the principal residence for two of the last five years (the “use test”).
The two years do not need to be consecutive.
The gain exclusion has not been used in the last two years.
Sometimes after a divorce, the spouse who gets the home in the divorce settlement may decide to sell and is seemingly unable to meet both the ownership test and the use test. Section 121 provides two special rules for divorced homeowners.
Section 121(d)(3)(A): Imputed ownership
When a home is transferred pursuant to a divorce, the imputed ownership tax rule allows the spouse who receives the home to use the former spouse’s period of ownership in order to qualify for the gain exclusion.
Let’s look at an example:
In 2010, Malcolm purchases a home in his name. In 2016, Malcolm meets Sheila and they marry and move into his house. In March 2019, the couple divorces and Sheila gets the home in the divorce. Six months later, Sheila sells the home. The home has appreciated since 2010, but if she can use the $250,000 exclusion, Sheila won’t owe any capital gains tax.
Does Sheila meet the use test? Yes, Sheila has lived in the home since 2016.
Does Sheila meet the ownership test? Sheila has owned the home for less than one year. However, because the home was transferred pursuant to divorce, Sheila can use Malcolm’s ownership period as her own. Therefore, Sheila meets the ownership test.
Section 121(d)(3)(B): Imputed use
A divorcing couple with minor children may decide to continue co-owning their home until their youngest child leaves home. Often, one spouse will continue to live in the home (the “in spouse”) and the other spouse will live elsewhere (the “out spouse”). The imputed use tax rule allows the out spouse to use the use period of the in spouse in order to qualify for the gain exclusion. One caveat is that the divorce decree must include language granting use of the home to the in spouse.
Let’s look at an example:
In 2000, Tim and Nancy marry and purchase a home. They are both on the home title. In 2017, Tim and Nancy decide to divorce and Tim moves into an apartment. They decide to keep their home until their youngest child graduates high school, and then they will sell. Their divorce decree grants Nancy exclusive use of the home. In 2022, their youngest child graduates and heads to college. Tim and Nancy sell their home for a significant gain. Tim and Nancy each hope they can use the $250,000 exclusion.
Does Nancy meet the ownership and use tests? Yes, Nancy has owned and used the home continuously since 2000.
Does Tim meet the ownership test? Yes, Tim has owned the home since 2000.
Does Tim meet the use test? Tim hasn’t lived in the home for several years. Fortunately, the divorce decree included language granting use of the home to Nancy. Tim can impute Nancy’s use of the property. Therefore, Tim meets the use test.
Advice for divorcing homeowners
If your home has appreciated in value, you may be on the hook for a significant tax bill when you sell it. Don’t keep the house in your divorce without first understanding the future tax consequences of selling it. There are special tax rules for divorcing and divorced homeowners. If you plan to keep the home after the divorce, be sure to talk to a tax professional.
Contact Serene Divorce Planning for help assessing the financial and tax implications of keeping the house in your divorce.
This information is educational in nature and should not be relied upon for legal or tax advice. Serene Divorce Planning LLC is not an attorney and does not provide legal or tax advice. Individuals seeking legal or tax advice should solicit the counsel of competent legal or tax professionals knowledgeable about the divorce laws in their own geographical areas. Serene Divorce Planning LLC does not sell or consult on securities.