Taxpayers could plan on how to apply the principal residence tax break of $250,000 for single taxpayers and $500,000 for married ones when getting married or divorced, or when converting another property into your home. In both marriage and divorce situations, a home sale usually occurs. The principal residence gain exclusion is very valuable when an appreciated home is at play.
Taxpayers should keep evidence of home repairs and renovation that increase their basis in the property to better determine their gain on the sale.
1. Sale during Marriage
In the case where a couple gets married and they each own separate residences from their single days. After the marriage, they jointly file their tax return. In this instance, it is possible for each spouse to individually passes the ownership and use tests for their respective residences. Each spouse can then take advantage of a separate $250,000 exclusion.
2. Sale before Divorce
When a soon-to-be-divorced couple sells their principal residence, assuming they still are legally married as of the end of the year of sale because their divorce is not yet final, the divorcing couple can shelter up to $500,000 of home sale profit in two different ways:
- Joint return. The couple could file a joint Form 1040 for the year of sale. Assuming they meet the timing requirements, they can claim the $500,000 joint-filer exclusion.
- Separate returns. Alternatively, the couple could file separate returns for the year of sale, using married-filing-separately status. Assuming the home is owned jointly or as community property, each spouse can then exclude up to $250,000 of his or her share of the gain.
To qualify for two separate $250,000 exclusions, each spouse must have
- owned his or her part of the property for at least two years during the five-year period ending on the sale date, and
- used the home as his or her principal residence for at least two years during that five-year period.
3. Sale in Year of Divorce or Later
When a couple is divorced as of the end of the year in which their principal residence is sold, they are considered divorced for that entire year. Consequently, they will be unable to file jointly for the year of sale. The same is also true when the sale occurs after the year of divorce.
Under preceding rules, both ex-spouses will typically qualify for separate $250,000 gain exclusions when the home is sold soon after the divorce. But when the property remains unsold for some time, the ex-spouse who no longer resides there will eventually fail the two-out-of-five-years use test and become ineligible for the gain exclusion privilege.
There is a way to avoid that unpleasant outcome.
Non-Resident Ex-spouse Continues to Own the Home for Years after Divorce
Sometimes ex-spouses will continue to co-own the former marital abode for a lengthy period after the divorce and only one ex-spouse will continue to live in the home. After three years of being out of the house, the non-resident ex-spouse will fail the two-out-of-five-years use test. That means when the home is finally sold, the non-resident ex-spouse’s share of the gain will be fully taxable. But with some advance planning this undesirable outcome could be prevented.
If you will be the non-resident ex-spouse, your divorce papers should stipulate that as a condition of the divorce agreement, your ex-spouse is allowed to continue to occupy the home for as long as he or she wants, or until the children reach a certain age, or for a specified number of years, or for whatever time you and your soon-to-be ex-spouse can agree on. At that point, either the home can be put up for sale, with the proceeds split per the divorce agreement, or one ex-spouse can buy out the other’s share for current fair market value.
This arrangement allows you, as the non-resident ex-spouse, to receive “credit” for your ex-spouse’s continued use of the property as a principal residence. So, when the home is finally sold, you should pass the two-out-of-five-years use test and thereby qualify for the $250,000 gain exclusion privilege.
The same strategy works when you wind up with complete ownership of the home after the divorce, but your ex-spouse continues to live there. By stipulating as a condition of the divorce that your ex is allowed to continue to live in the home you ensure that you, as the non-resident ex-spouse, will qualify for the $250,000 gain exclusion when the home is eventually sold.
IRC section 121
IRC section 1041(a)
Treas. Reg. section 1.121
Treas. Reg. section 1.121-4(b)(2)
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