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. Here is what happens tax-wise to a divorcing couple’s marital home or principal residence, which may be one of their biggest assets.
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 (marital home) 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. 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.
If you are in the process of divorcing, and you sell your principal residence (marital home) before the divorce is not yet final, you will be 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, you and your almost ex can each exclude up to $250,000 of your share of the gain. 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.
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.
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. But, there is a way around that problem.
If you’ll be the non-resident ex, insist that the divorce papers stipulate that, as a condition of the marital settlement 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 settlement 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.
The above though is not true for vacation homes which are ineligible for the gain exclusion break. If you chose to have your ex spouse buy you out of the vacation home, 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.
Ronald Lieberman, Esq. is a shareholder and partner at ALBFRM in Haddonfield, New Jersey. A fellow in the American Academy of Matrimonial Lawyers and a Certified Matrimonial Attorney by the New Jersey Supreme Court, Ron handles all matters relating to divorce and family law.