How Divorce Affects Eligibility for the Home Sale Gain Exclusion

It's common for couples who divorce to sell their homes. Not only does this move give former spouses fresh starts after the divorce is finalized, but it can also free up cash to help divvy up the marital estate. If you're facing this situation and your principal residence has appreciated substantially while you've owned it, you don't want to lose out on the home sale gain exclusion. This tax break can save you significant tax dollars. But timing can be critical.

An unmarried person can potentially shelter up to $250,000 of gain on the sale of his or her principal residence from federal income tax. But the home sale gain exclusion can be worth twice as much for a still-married couple if certain conditions are met. Here's what divorcing couples should know to help them take full advantage of this valuable break.

Basics of the Home Sale Gain Exclusion

To be eligible for the home sale gain exclusion, you must pass two tests:

1. You must have owned the home for at least two years during the five-year period ending on the sale date.
2. You must have used the home as your principal residence for at least two years during the five-year period ending on the sale date.

While still married, you can exclude up to $500,000 of gain from selling a principal residence on your joint tax return, if at least one spouse passes the ownership test, and both spouses pass the use test. After divorce, special considerations apply.

Important: The ownership and use tests are completely independent, so periods of ownership and use don't need to overlap. For purposes of the tests, two years means periods aggregating to 24 months or 730 days.

You also need to pass the anti-recycling test to be eligible for the home sale gain exclusion privilege. To pass this test, you must not have excluded an earlier gain within the two-year period ending on the date of the later sale. In other words, you generally can't recycle the gain exclusion privilege until two years have passed since you last used it.

While still married, you can only claim the larger $500,000 exclusion for married-filing-jointly couples if neither you nor your spouse took advantage of the gain exclusion break for an earlier sale within the two-year period.

Selling While You're Still Married

If you and your soon-to-be-ex-spouse sell your principal residence in a year before your divorce is finalized by the court, Uncle Sam will still consider you married for that year for federal income tax purposes. Although you're still considered married for tax purposes, you can potentially shelter up to $500,000 of home sale gain in two different ways:

1. File a joint tax return for the year of sale. You can claim the larger $500,000 joint-filer exclusion if you pass the ownership and use tests. (See "Basics of the Home Sale Gain Exclusion" above.)
2. File separate returns for the year of sale using married-filing-separate status. Assuming the home is owned jointly or as community property, each spouse can exclude up to $250,000 of his or her share of the gain. To qualify for two separate $250,000 exclusions, each spouse must pass both the ownership and use tests.

In many cases, the preceding rules will allow a divorcing couple to convert their home equity into cash without owing any federal income tax on the transaction.

Selling in Year of Divorce—or Later

When a couple is divorced as of the end of the year in which their principal residence is sold, they're considered divorced for that entire year for federal income tax purposes. Therefore, they can't file jointly for the year of sale. The same is true when the sale occurs after the year of divorce. Can you claim the home sale gain exclusion in these situations? It depends on the circumstances.

For instance, under the terms of a divorce agreement, Andy was awarded sole ownership of a home that was previously owned by his ex-spouse, Briana. For purposes of the home sale gain exclusion, Andy is allowed to count Briana's period of ownership for purposes of passing the two-out-of-five-years ownership test when he eventually sells the property. Andy's maximum gain exclusion will be $250,000, because he's now single. However, if he remarries and lives in the home with his new spouse for at least two years before selling, he can qualify for the larger $500,000 joint-filer exclusion.

Bill and Sandy face a different situation. Under the terms of their divorce agreement, both spouses retained a percentage ownership of the home. When the home is later sold, both Bill and Sandy can exclude $250,000 of their respective shares of the gain, provided each person passes both the ownership and use tests.

Important: If the former marital home remains unsold for some time, the ex-spouse who no longer resides there will eventually fail the two-out-of-five-years use test and become ineligible for the gain exclusion privilege. But there's a simple way to avoid that outcome.

Post-Divorce Ownership

Sometimes ex-spouses will continue to co-own the former marital residence for a long time after their divorce has been finalized. After three years of being out of the home, the "nonresident ex" will fail the two-out-of-five-years use test. As a result, when the home is eventually sold, that person's share of any gain will be fully taxable.  

Nonresident ex-spouses can preserve their gain exclusion privilege by stipulating in divorce agreements that their ex-spouses can continue to occupy the home:

• For as long as an ex-spouse wants,
• Until the kids reach a certain age,
• For a specified number of years, or
• For any other time period the parties agree to.

At that point, the home can either be put up for sale with the proceeds split per the divorce agreement or one ex-spouse can buy out the other's share. This arrangement allows nonresident ex-spouses to receive "credit" for their former spouse's continued use of the property as a principal residence. So, when the home is finally sold, the nonresident ex should pass the two-out-of-five-years use test and qualify for the $250,000 gain exclusion privilege.

The same strategy works when spouses with complete ownership of a home after a divorce allow their ex to continue living there. Stipulating, as a condition of the divorce, that the soon-to-be-ex is allowed to continue to live in the home ensures that the nonresident ex will qualify for the $250,000 gain exclusion when the home is eventually sold.

Hypothetical Scenarios

Here are some fictitious examples: Dave and Della get divorced in 2023. Each party retains 50% ownership of the former marital residence. As a specific condition of the divorce agreement, Della is allowed to continue living in the home for up to six years, until the couple's youngest child reaches age 18. Then Della must either buy out Dave's 50% ownership interest or cooperate in selling the home.

Let's assume that the property is sold six years after the divorce (in 2029) and that there are no changes to the tax law as it relates to the home sale gain exclusion. With respect to his 50% ownership interest, Dave still passes the two-out-of-five-years ownership and use tests, even though he hasn't lived in the home for six years. That's because he made sure the divorce agreement included a provision specifically permitting Della to continue to reside in the home as a condition of the agreement. Therefore, Dave can count Della's continued use of the property as her principal residence as continued use by Dave. That means Dave will qualify for the $250,000 gain exclusion privilege when the home is sold six years post-divorce. He can use the exclusion to shelter all or part of his share of the home sale gain.

Important: If Dave's attorney fails to include that stipulation in the divorce agreement, Dave will be taxed on his share of the home sale gain when the property is sold six years after the divorce.

Della will also pass the ownership and use tests if the home is eventually sold. She'll qualify for a separate $250,000 gain exclusion, assuming she remains single. However, let's say Della remarries. She and her new husband, Max, live in the home for at least two years before the sale date. With respect to her share of the home sale gain, Della can qualify for the larger $500,000 exclusion by filing a joint federal income tax return with Max for the year of sale. Dave still qualifies for a separate $250,000 exclusion, even though Della remarried.

How would the tax outcome change if Dave was awarded full ownership of the former marital residence after the divorce (instead of a 50% ownership interest)? In this scenario, the couple's divorce agreement stipulates that, as a specific condition in the divorce agreement, Della can continue to reside in the home for up to six years. After that, Dave can sell the home at any time by giving Della three months' notice of his intent to sell.

Assuming the property is sold six years and three months after the divorce, Dave will pass the two-out-of-five-years ownership and use tests even though he hasn't lived in the home for over six years. So, he qualifies for the $250,000 gain exclusion privilege, which he can use to shelter all or part of his home sale gain.

Important: If Dave's attorney fails to include that stipulation in the divorce agreement, Dave will be taxed on the entire home sale gain six years and three months after the divorce.

Exceptional Gains

If you have a gain on the sale of your home that exceeds the allowable exclusion, the excess gain is a long-term gain if you've owned the property for over one year. The current maximum federal rate on long-term gains is 20%, but most people won't owe more than 15%. However, you might also owe the federal 3.8% net investment income tax (NIIT) on the taxable portion of your gain, and you might owe state income tax, too.

For More Information

While home prices have cooled off in many areas, your home may still be worth a lot more than you paid for it. If so, the principal residence gain exclusion break can be a big tax saver, especially for soon-to-be-divorced couples who are considering selling homes they owned while married. Contact your SSB tax advisor to determine the optimal tax treatment for your situation.

©  2023