With the passage of the Taxpayer Relief Act of 1997 (TRA ’97) a single homeowner can now exempt $250,000 in capital gains from the sale of a principal residence ($500,000 for a married couple) provided that the homeowner had occupied that home as a principal residence for two of the five years preceding the sale. The only exception to the rule is for unforeseen circumstance (as defined in IRA Publication 523). Before TRA ’97, if one spouse left the house two years before their divorce was final, they lost their ability to roll forward their capital gain.
The same rules apply under divorce; however, divorcing taxpayers may still qualify for the exclusion if they do not meet the technical requirements of the ownership and use tests.
If, as a condition of a divorce agreement, one spouse is required to grant the other spouse the right to temporary possession of the home, but retains title to the home, and the home is later sold, the non-occupying spouse will be treated as having owned the home for the period of time that the occupying spouse was granted temporary possession of the home.
In the event one spouse transfers a residence to the other as a condition to a divorce decree, the “transferring spouse” shall be able to include the “receiving spouse’s” use period in computing their own use period.
Note: If one or the other remarries prior to sale of home jointly owned with the former spouse, the new spouse can use the remarried spouse’s time in the home to meet residency requirements to use the “married filing jointly” exclusion amount.
Let’s look at an example.
Don and Mary are getting divorced. As a condition of their divorce agreement, Mary is going to remain in the jointly owned family home for six years until their son graduates from high school. At the end of six years, Mary will sell the home and 50% of the proceeds will be sent to Don. Mary sells the home for $750,000. Mary and Don will each receive $375,000. If the basis in the property was only $100,000, Mary’s portion of the basis is $50,000 leaving her with $325,000 gain. Mary satisfies both the use and ownership tests and after she uses her $250,000 exclusion, she will be taxed on $75,000 of gain. As the non-occupying ex-spouse, Don does not pass the use test, however because they specifically made this a condition of their divorce agreement, Don is permitted to apply Mary’s use period toward satisfying his own use test. As a result, he may exclude $250,000 from his tax computation. His capital gain from the sale would also be only $75,000.
$750,000 Sales price $750,000 Sales price
100,000 Basis 375,000 Don’s half
$650,000 Capital gain $375,000 Mary’s half
$375,000 half of Sales Price $375,000
50,000 half of Basis 50,000
$325,000 half of Capital Gain $325,000
-250,000 Exclusion -250,000
$75,000 Amount each is taxed on $75,000
For this to work, both Mary’s and Don’s names have to stay on the deed so that the IRS knows that Don is entitled to his exclusion. This arrangement also has to be stated in the divorce decree.
Many times the gain is mistakenly assumed to be simply the profit on the sale (home was purchased for $100,000 and sold for $750,000 equaling a $650,000 difference). This is incorrect. The gain is actually the home’s selling price, minus deductible selling costs, and the tax basis in the property. The tax basis in the property is the original purchase price, plus the cost of capital improvements, minus any depreciation and certain other expenses incurred at the time of sale.
What if, in the 2nd year Mary gets married, and subsequently sells the house? Provided that her new spouse occupies the house as his principal residence for at least 2 years, he will have satisfied the use test because he lived in the home for the requisite period. Because only one spouse must satisfy the ownership test, her new spouse will also be able to take an exclusion provided they file a joint tax return.
One good thing that TRA “97 gave us is that this is not a one-time exclusion. This exclusion can be used over again every two years provided that taxpayers meet the ownership and use tests.