How Divorce Affects the Capital Gains Tax Exemption on Sale of a Couple’s Home

Federal tax law provides for special treatment of capital gains taxes on the sale of a person’s residence provided certain conditions are met. A taxpayer may qualify to exclude up to the first $250,000.00 of the capital gain from the sale of a home. When a married couple owns the home, they can each use their $250,000.00 exemption and avoid taxation on up to $500,000.00 in appreciation. The problem arises when a couple divorces. How does divorce affect the capital gains tax exemption?

Generally, each party will qualify for the exclusion if they meet the ownership and use test, i.e. if each has owned and used the home as his/her main residence for a period aggregating at least two years out of the five years prior to its date of sale. In the case of separation and divorce, certain exceptions have been created because often one spouse does not technically meet the ownership and use test. The IRS states:

“If you were separated or divorced prior to the sale of the home, you can treat the home as your residence if:

• You are a sole or joint owner, and
• Your spouse or former spouse is allowed to live in the home under a divorce or separation agreement and uses the home as his or her main home.

If your home was transferred to you by a spouse or ex-spouse (whether in connection with a divorce or not), you can count any time when your spouse owned the home as time when you owned it. However, you must meet the residency requirement on your own.”

In addition, a divorced spouse may use the other spouse’s $250,000.00 capital gains exemption, notwithstanding that the other spouse left the marital residence if certain conditions are met, including that the other spouse’s departure was pursuant to a separation agreement, the spouse residing in the marital home did so continuously until it was sold, and the sale was within 6 years of the divorce.

Preserving the $500,000.00 tax exemption is an important tax benefit as it offers significant tax savings to a party when appreciation on a marital home exceeds $250,000.00. If you are considering a divorce, please contact an experienced attorney at our firm who understands the tax implications of any financial settlement in your divorce.