Divorce and Gain Exclusion

For most couples contemplating divorce, the largest single asset at issue is their personal residence. In most situations, one spouse moves out of the residence during the separation and divorce proceedings. Tax consequences are often ignored, as the primary concern is the division of marital assets. However, focus normally returns to the tax consequences when considering the disposition of the personal residence and the after-tax effect on valuing the home for the purpose of dividing the couple’s assets.

There are normally three ownership variations with respect to the former marital residence: joint ownership, transfer to one spouse, and joint ownership with only one inhabiting the house.

Both Spouses Own Home Jointly

As long as both spouses meet the two-out-of-five-year ownership and use rules under Sec. 121 and are not deemed ineligible because of the prior use of the exclusion during the two-year period ending on the residence’s sale date, each spouse can shelter up to the $250,000 exclusion. Under Regs. Sec. 1.121-2(a)(2), this exclusion is allowable even if the spouses file separately (or, if divorced, file as single persons).

Example 1: G and B are divorced in 20X1. In July 20X2, they sell the marital residence that they had both owned and used for at least two out of the last five years. The home is sold at a $300,000 gain. Each is able to exclude $150,000 on their returns filed as single taxpayers.

Ownership Transferred to One Spouse

When a spouse obtains ownership from a spouse or former spouse under Sec. 1041(a), the period that the recipient spouse is deemed to have owned the property includes the period that the transferor spouse owned the property; see Sec. 121(d)(3)(A) and Regs. Sec. 1.121-4(b)(1). Assuming the recipient meets the two-out-of-five-year use rule on his or her own, both spouses are eligible to use the $250,000 exclusion under Sec. 121.

Example 2: During R and N’s 30-year marriage, R retained sole ownership of the personal residence. On their divorce last year, R transferred his ownership to N. This year, N sold the home and realized a $225,000 gain. N’s entire gain will be excluded under Sec. 121, because she meets the two-out-of-five-year use test on her own. She also meets the two-out-of-five-year ownership test, because she can tack R’s ownership onto her own.

Joint Ownership with Only One Resident

For purposes of the home-exclusion rule, a taxpayer can be treated as using the principal residence during the period of ownership that the taxpayer’s spouse or former spouse is granted use of the home under a divorce or separation agreement that meets the criteria of Sec. 71(b)(2); see Sec. 121(d)(3)(B) and Regs. Sec. 1.121-4(b)(2).

Example 3: After their divorce, S and C continue to own their former marital residence. S moves out of the house. Under the divorce instrument, C is awarded use of the property and continues to use it for the next five years. If S and C sell the property in the fifth year, S (as well as C) can use the Sec. 121 exclusion because S will have met the ownership test on his own and will meet the use test by tacking on C’s use of the property.

Given the proper facts and circumstances, there may actually be an opportunity to increase the total Sec. 121 exclusion from $500,000 to $750,000 for the eventual sale of a former marital residence.

Example 4: C from Example 3 marries M shortly after her divorce from S. The home is sold five years later. S, C and M have all used the home for at least two out of the last five years. Under Sec. 121(d)(3)(B), S can tack his actual use onto C’s, and C and M meet the use test on their own. S and C also meet the two-year ownership test on their own. If C and M file a joint return in the year of the property sale, an additional $250,000 could be used because, on a joint return, only one spouse needs to meet the ownership re-
quirements for the exclusion under Sec. 121(b)(2)(B) to apply. Thus, S can use an exclusion up to $250,000, while C and M can use an exclusion up to $500,000.

Unfortunately, tax planning for the Sec. 121 exclusion normally becomes a last-minute drill for most divorce proceedings. It is important for the tax adviser to bring this issue to light early, so that both parties can contemplate its effect and maximize the tax efficiency in disposing of the couple’s former residence.