In property settlements, transfers between spouses are gifts and are not taxable. However, in order to pay a settlement, sometimes couples must disturb assets in a way that creates tax consequences. For example, taxes may result when a party must withdraw funds from a pension fund.
Capital gains tax is not always an issue for most divorcing spouses. Capital gains of up to $500,000 can be sheltered from the sale of the primary residence, but the sale of other real estate may result in taxable revenue.
Other situations where taxes should be considered is when divorcing when the couple is selling an asset that is received as a result of a settlement; the marital home for example may create a capital gains liability. This is not contrary to the above statement where capital gains is not an issue for most divorcing spouses. This is when one spouse receives the marital home as part of the settlement and the home is not sold at the time of the divorce; when one of the parties take future income from the asset to be received later.
In divorce both parties should understand the basis for sheltered property, which includes the original cost, minus any improvements. Under tax laws, each spouse may exclude up to $250,000 (or $500,000 as couple) from any capital gains tax if they lived in the house for any two of the last five years.
The couple must decide how to divide the marital home, and take into consideration any capital gains tax that affects the party. In general, transfers of property between divorcing spouses are nontaxable. But there are circumstances where the capital gains tax (a tax on profits from sales of property where the gains exceed a certain amount) do apply to transfers that are made as part of a divorce.
If the parties sell the marital home, each can exclude the first $250,000 of gain from taxable income. The capital gains exclusion applies only to the marital home if it was the primary residence that both parties for at least two of the five years before the sale of the home.
Military members can extend the five-year time frame to up to 10 years under certain circumstances.
The capital gains exclusion does not apply to a vacation home.
To figure out your taxable gain, you take the selling price of the home, minus any selling expenses, minus the amount that was originally paid for the house (or the cost to build the home). There may be some leeway for improvements to the home during the course of the marriage.
When one spouse is buying out the other, the sale is part of the divorce so the seller doesn’t really have to worry about any capital gains.
On the other hand, however, the buyer who stays in the house and later sells the home may only exclude the first $250,000 of gain, remember however, that you must live in the home 2 years before you sell the house or you need to meet one of the IRS exceptions to that rule.
Co-Owning the House
When both spouses continue to own the house but one of the spouses no longer lives in the home, he or she risks losing the $250,000 exclusion when the house is sold.
To avoid losing the exclusion, the spouses should make sure there is a written agreement of co-ownership. It must be made clear that the arrangement is pursuant to a divorce settlement or court order and that the agreement states both spouses remain co-owner but only one spouse lives in the home.
Capital gains can be confusing. Make sure you read and try to understand the IRS Publication 523, which may address some of the issues. If nothing else, contact a tax attorney or accountant to discuss how capital gains may affect you in your divorce.