Tax Implications for Personal Residences in Divorce

A personal residence is an important piece of property that requires careful consideration in any divorce case. It is often the major asset owned by the spouses. The tax provisions regarding personal residences are quite complex.

IRC Sec. 1034 allows a tax-free rollover of the gain on the sale of a personal home provided another residence is purchased within two years from the date of sale. The purchase price of the new residence must be greater than the sales price of the old residence in order to defer gain.

The law also allows a one-time election to exclude $125,000 of gain on the sale of a personal residence under IRC Sec. 121. The homeowner must be age 55 or older on the date of the sale and must have used the residence as his or her principal residence for at least three of the previous five years.

A couple jointly owning a home generally has the three following options in dealing with the residence:

Sell the house immediately

Transfer the interest in the house of one spouse to the other

Continue joint ownership with one spouse living in the house until the sale at a later date

Each of the options involves important income tax consequences which must be understood in order to determine the best option to fit the couple’s circumstances.

SALE OF RESIDENCE INCIDENT TO DIVORCE

When the jointly-owned house is sold immediately to a third party, the sale is treated as if each spouse has sold his or her one-half interest in the home. Both spouses will have to report a gain on the sale unless each separately qualify for the tax-free rollover of the gain by purchasing a replacement residence of equal or greater value within two years from the date of sale or unless they qualify for the $125,000 one-time exclusion for taxpayers over age 55. The following examples illustrate the tax consequences:

Example 1: H & W purchased a home in 1975 for $60,000. As part of their divorce in 1991, they sold the home for $260,000. They are both under age 55 and do not qualify for the exclusion. Each spouse realizes $100,000 of gain. W buys a replacement residence for $175,000 later that year. H does not buy a replacement residence.

W qualifies for the tax-free rollover of her share of the gain into the new residence since the $175,000 purchase price exceeds her share of the sales price ($130,000) and she bought the house within two years. H does not qualify for a tax-free rollover because he did not purchase a replacement residence. H must recognize his entire $100,000 gain in the year of sale. If H & W filed jointly in 1991, the return must be amended to report H’s gain on the sale. Since spouses are jointly and severally liable for taxes on joint returns, W would be liable for H’s gain, including any penalties and interest. It may be prudent to include a clause in the separation agreement or divorce decree stating that each spouse is liable for his or her share of the gain.

If a replacement residence is not purchased and one of the spouses is over age 55 at the date of the sale, the one-time exclusion may be used. The exclusion applies to both spouses if they were married at the date of the sale. If one spouse uses the election while married, no future elections are available to either spouse.

Example 2: Same facts as Example 1 except H is 58. H can elect to exclude his entire $100,000 share of the gain. If H & W were married at the date of the sale, they are both precluded from electing the exclusion in the future. This applies to each spouse even after the divorce and will also apply to a new spouse should either remarry.

If the couple sells the house after divorce, they are treated as separate taxpayers and each ex-spouse is entitled to a $125,000 exclusion.

TRANSFER OF HOUSE INTEREST TO OTHER SPOUSE

All transfers of property between spouses are treated as non-taxable gifts under IRC Sec. 1041. Even if a spouse receives consideration for a transfer of interest, no gain is recognized and the tax basis in the property carries over to the recipient. If the spouse who now owns the entire house decides to use it as a personal residence, that spouse is eligible for the tax-free rollover or one-time exclusion on a subsequent sale on the entire gain, including that obtained from the other spouse.

Example 3: Same facts as Example 1 except H purchases W’s share of the home for $70,000. The transfer is considered a gift of $70,000 and thus no gain is triggered. All of the potential gain on the future sale is transferred to H. The future tax liability for the entire gain on the house sale should be considered in the distribution of assets.

SALE OF HOUSE AFTER ONE SPOUSE MOVES OUT

It is common for one spouse to move out and for the other spouse to remain in the jointly-owned house with the children until the children leave home. The house is then sold and the proceeds divided at that time. The tax law provides that the tax-free rollover of the gain on sale and the one-time exclusion election are available only to the taxpayer who sold a principal residence. The spouse who moved out does not qualify as a principal resident if the house is sold more than two years after the spouse leaves. This spouse must then recognize the entire gain attributable to his one-half interest in the house. The spouse who moves out should be informed that he will be liable for his share of the future gain on sale should this problem not be addressed in the divorce or separation agreements. Consider adding a clause to the divorce settlement that provides that each spouse bears an equal burden of any taxes paid on the gain.