For most divorcing spouses, the sale of the family house during or after a divorce probably will not result in any capital gains tax. The sale of a primary residence can be sheltered from capital gains of up to $500,000, but the sale of other real estate may result in taxable events.
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 restricted account, such as a pension fund. Other situations where taxes must be considered is the sale of assets received in a settlement, such as a house, which may create a capital gains liability; when both parties make an in-kind distribution of property, such as set-off and trades; when the parties take future income from a pension to be received later.
At the least, in divorce both parties should know the basis for the sheltered property — the original cost, minus improvements. Under current tax laws, each spouse may exclude up to $250,000 (or $500,000 as couple) from any capital gains tax if they have lived in the house for any two of the last five years.
Whether and how the capital gains tax affects a party in a divorce depends on what he or she does with the house. 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 their house, each excludes the first $250,000 of gain from taxable income. The capital gains exclusion applies only to the “principal residence,” which is defined as a home in which you’ve lived for at least two of the five years prior to the sale. A vacation house doesn’t count.
A taxable gain is the selling price of the house, minus the selling expenses, minus your adjusted “basis.” Basis is the amount paid for the house or the amount it cost built, with some pluses and minuses for improvements and tax benefits. Of course, being tax related, the basis is not always simple to figure out.
When either spouse is in the military that five-year period can be extended for up to ten years under some circumstances.
In a buyout, the selling spouse doesn’t need to worry about capital gains tax because the sale was part of the divorce; however, the buyer who stays in the house and later sells it to a third party may exclude the first $250,000 of gain—as long as he or she lived there for two years before selling, or meet one of the IRS exceptions to that rule.
Co-Owning the House
A spouse who continues to own the house but doesn’t live in it risks that the $250,000 exclusion might not apply when the house is sold. To avoid losing the exclusion, written documentation of the co-ownership agreement is important. It must be clear that the arrangement was pursuant to a divorce settlement or court order, and that the agreement called for one spouse to stay in the house and the other to leave but remain a co-owner.
Capital gains can be confusing. IRS Publication 523, Selling Your Home, can be helpful.