The Marital Home in Taxes During Divorce
Key Points
  • When you are thinking about divorce, and if you have a marital home, you need to think long and hard about whether the tax implication could financially harm you if you keep the home.
  • Financially are you able to keep the home in the wake of a divorce?
  • The family home may have sentimental value but is very often the most barren asset in the midst of a divorce.
  • If you are selling the marital home, make sure you understand your financial responsibility and any tax implications that may affect you.

Sale of the marital home is often the only option if both parties are to receive an equitable share in the distribution of joint assets, but the sale of a house can expose the owners to taxes. Since 1997, each spouse may exclude up to $250,000 (or $500,000 as a couple) from any capital gains tax if the spouses have lived in the house for any two of the last five years.

This capital gains exclusion can work against a single house owner who takes the house as part of the settlement, and then sells it later as a single person for more than $250,000. If the house sells for more than $250,000 more than they paid for it, the owner will owe taxes.

A caveat for the divorcing: the house must have been the principal residence for two of the past five years when it is sold. That means, effectively, that the house must be sold within three years after a spouse departs. Its common these days in divorce for one of the spouses to move out of the house but to continue to own an interest in it for several years. Once a party is gone for more than three years, the house is no longer the principal residence. If it is sold at gain, taxes are owned. However, if a spouse moves out and his or her former partner has the right to live in it pursuance to the divorce, that spouses residence in the house will be counted for calculating the two year requirement.

The recently divorced have an advantage. If he or she moved out of the house before the divorce was final, and then ended up getting the house in the proceedings anyway, the person can still claim the house as a primary residence.

The decision to keep a home requires thinking long term and short term. At the least, both parties should know the basis for the property - the original cost, minus improvements.

Very often a person realizes after the divorce that he or she cannot afford the house conveyed as part of the property settlement. The person awarded the marital home should be certain that he or she can afford to keep it. Courts are very inclined to award the house to the mother so that school-age children experience the least disruption, particularly in states where judges have discretion in the equitable distribution of property. This means that the equitable distribution of property may result in the marital home going to a mother.

The disposition of the family home can be charged with emotion, particularly for a wife who made the home a nest where she raised the children. Selling the house and splitting the proceeds is probably the most common route, but some couples agree to have one spouse buy out the others interest, or continue to own the house jointly. Each of these approaches has advantages, depending upon the situation of the divorcing couple.

Selling the house, a very common course, raises possible tax considerations, the problems of renting versus buying, and getting a new mortgage.

A buy out by one spouse requires that the house be appraised independently. In this routine, after an appraisal, some couples dividing marital property often use a property settlement note. In this arrangement, one spouse pays the other a sum for a negotiated length of time at current interest rates. A buy out gets one spouses name off the title, but it normally leaves his or her name on the mortgage. This may have an impact on a partys credit rating.

Joint ownership often appeals to couples that want to keep their children in the same house until they finish school. In this arrangement, when the divorce happens, the couple become tenants in common, which means they each own half the house. Normally, the couple works out arrangements whereby one party, the one who stays in the house, pays the mortgage, while all other costs are split evenly. When the children finish school, the parties sell the house and split the proceeds.

If the house must be sold, the provisions of the sale should address how, when, by whom and in what manner that sale is to happen. These terms and conditions become even more important now as the housing market stagnates.

While the sale of a primary residence can be sheltered from capital gains of up to $500,000, the sale of other real estate may result in taxable events.

The rollover provision, which required taxpayers to roll the money from one house to a more expensive house, has been eliminated. Until 1997, a couple who wanted to claim the capital gains tax exclusion on a primary residence had to purchase a new home of equal or greater value than the one they sold. The rollover provision has been eliminated, so a divorcing couple can take the exclusion without buying another home.

Despite the collapse of the housing market, spouses must consider the capital gains. A couple who bought a house in the early part of the housing boom may face considerable capital gains because the stratospheric prices of the housing market moved the house far above what the couple paid for it. If a person realizes more than $250,000 (if single) or more than $500,000 (if married, filing jointly), the gain will be taxed at 8 percent or 18 percent, depending upon income.

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INNOCENT SPOUSE RULE -- Section 434(c)(1) of the Internal Revenue Code protects an innocent spouse from tax fraud prosecution under certain conditions. This rule mainly protects women who innocently sign returns while married to men who controlled the finances. An innocent spouse can be protected from liability if 1) a joint return was filed, 2) the return contains a "grossly erroneous" error, 3) he or she establishes "lack of knowledge," and 4) it is "inequitable" to impose the tax on him or her. This rule does not protect the spouse from any legitimate tax obligations for which he or she is responsible under joint and several liability.

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