The home is often a key asset in marital disputes and may be significant for monetary or nonmonetary reasons. Regardless of the circumstances, divorcing individuals and their lawyers need to understand the tax consequences associated with transferring or selling the marital home.
Section 1041 of the Internal Revenue Code (§ 1041) contains mandatory rules that apply to all transfers of property between spouses or former spouses that are “incident to divorce.” Under § 1041, no gain or loss on the property transfer is recognized by either spouse, and the basis of the property transferred carries over to the transferee spouse.
A property transfer is “incident to divorce” if it: (i) occurs within one year of the cessation of the marriage; or (ii) is “related to the cessation of the marriage.” The latter is true of a transfer of property if it: (i) is made pursuant to a divorce or separation instrument; and (ii) occurs within six years of the date of divorce. § 1041 applies even if the transferred property is acquired by the transferor spouse after the divorce is final. As long as the transfer occurs within one year of the divorce, the same rules will apply even if the transfer is not required by the divorce or separation instrument.
The Principal Residence
As a general rule, single taxpayers can exclude from gross income $250,000 of gain realized on a qualified sale of their principal residence (joint filers can exclude $500,000). If the home is owned jointly but separate returns are filed, each person can exclude $250,000. The exclusion can only be utilized once every two years. Remember, however, that a § 1041 transfer would not trigger gain recognition (i.e., not treated as a sale).
To qualify for the exclusion, the taxpayer (or the taxpayer’s spouse) must have owned and used the home as the principal residence for two of the five years prior to the sale. It need not be 24 consecutive months, and the ownership and use tests can be met over different periods of time. For married taxpayers filing a joint return, understanding the ownership and use tests is pretty straightforward. For separated and divorced couples, it may be more difficult.
Special tax rules offer divorcing couples an option that can provide real tax savings. With respect to the ownership test, the transferee spouse is considered to have owned the home during any period of time in which the transferor spouse owned it. With respect to the use test, the transferee spouse and transferor spouse are considered to have used the principal residence during any period of time in which (i) the ownership test is met; and (ii) the transferee spouse was allowed to live there under a divorce or separation instrument and it is used as the main home.
Division of the marital estate can sometimes be tricky, and understanding the financial aspects of a settlement can be challenging. Property division can end up being inequitable if one party inherits a significantly better or worse tax situation. This article only provides an overview of the tax rules related to selling a principal residence in the context of a divorce, and a detailed analysis of the possible fact patterns is beyond its scope. Family lawyers and divorcing parties should consult a CPA for tax advice on specific situations.
Stuart Rosenberg, CPA, CVA, CFF is the practice leader for Forensic & Valuation Services at Aronson LLC.
Bill Foote, CPA, CVA, ABV, CFF, CFE serves as a Partner in Aronson’s Forensic & Valuation Services practice.
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