A residence is often a married couple’s most significant asset. As a result, monetary and tax considerations for property settlements related to the marital residence are usually extremely important to divorcing taxpayers. Specifically, to qualify for the exclusion of up to $250,000 of gain on the sale of the residence, a spouse must satisfy both of the two-out-of-five years ownership and use tests. In addition, the tax consequences associated with a future residence sale are often considered when valuing the home for purposes of dividing assets. In a typical divorce, one spouse moves out of the residence and divorce proceedings, which may take several months to several years to complete, commence. In dividing up the marital estate, the marital residence is usually disposed of in one of three ways.
Residence Sold as Part of Divorce Proceedings. The divorce agreement may specify that the residence must be sold as part of the divorce process so the proceeds can be split between the spouses. If they independently meet the ownership and use requirements, each spouse’s share of the gain can be sheltered up to $250,000. The fact that each spouse files a separate return or they each file as single persons for the year of sale does not make a difference.
Example: Immediate sale of residence after divorce.
Jane and Mike Jones were divorced in January. In April, they sell the home they owned jointly and used as a principal residence for 15 years. The home is sold for $800,000, resulting in a gain of $400,000. They both meet the two-out-of-five year ownership and use tests. Therefore, each of them can exclude their $200,000 share of the gain.
Ownership Transferred Incident to Divorce. If the transfer of ownership of the principal residence from one spouse to the other is made during marriage or in a divorce, neither spouse recognizes gain or loss on the transfer. The receiving spouse’s basis in the residence is the combined basis of both spouses before the transfer. If a taxpayer transfers a residence to a spouse or former spouse incident to a divorce, the transferee’s period of ownership includes the transferor’s ownership period, making that spouse eligible to exclude the sale gain.
Example: Exclusion of gain after transfer to spouse incident to divorce.
For 25 years, Tim and Fran James used a home owned by Tim as their principal residence. They divorce and pursuant to their divorce decree, Tim transfers ownership of the home to Fran. Six months later Fran sells the home at a $200,000 gain. She can exclude the gain because she meets the two-out-of-five years use test, and also meets the two-out-of-five years ownership test because she can include Tim’s ownership period as though it was her own.
Delayed Sale of Residence under Divorce Agreement. For divorcing couples with children, it is fairly common for one spouse to move out and the other to reside in and maintain the home for the children. After the children complete school or otherwise move away from home, the home is often sold and the proceeds divided between the now-divorced spouses.
For purposes of the gain exclusion rules, a spouse who continues to own all or part of the marital residence, but no longer resides there (i.e., the nonresident spouse), is considered to be using the residence as a principal residence
while such taxpayer’s spouse or former spouse is granted use of the property under a divorce or separation agreement.
Example: Meeting the use test for delayed sale pursuant to divorce.
Randy and Ann have jointly owned their residence for seven years. They divorce and Ann moves into an apartment. The decree states that Randy can live in their jointly-owned house until it is sold, and he does so. Four years later, the house is sold at a gain of $300,000 and the proceeds are split between Randy and Ann pursuant to the divorce decree. Each former spouse can exclude their $150,000 share of the gain. In meeting the use test, Ann is considered to be using the house as her principal residence during the time Randy resides there. Randy meets the use test because he actually lives in the residence.
Tax planning is an important aspect of dealing with a divorce. Please contact us to discuss the tax issues associated with a divorce or any other tax compliance or planning matter.