Divorce and Taxes Impact on Property Division

Divorce is an emotional rollercoaster. And suppose you’re a woman who’s going through or about to go through a divorce. In that case, you need to be keenly aware of this: People tend to make absolutely terrible financial decisions when they’re on that rollercoaster, feeling up one minute and then down the next. Under the circumstances, a measure of indecision and confusion is completely understandable. Suppose one is in the early stages of divorce. In that case, it may be a mixed bag of emotions, anger, betrayal, loss, shock, numbness, confusion, panic, which may lead to not thinking clearly about financial matters, such as how your assets might get divided, tax liabilities, and what your living expenses might be ten years from now.

But here’s the problem: When you’re divorcing, you simply cannot risk being uninformed, indecisive, or bewildered about your finances. After all, the decisions you make both before and during your divorce will directly impact the rest of your life, for better or for worse.

The Marital Residence and Financial Implications

The marital residence frequently is one of the most valuable assets a couple owns, and monetary and tax considerations related to dividing the residence are usually very important to a divorcing couple.

Taxpayers may exclude up to $250,000 ($500,000 if married filing jointly) of realized gain on the sale of a principal residence, but this exclusion can only be used once every two years. There is no absolute limit on the number of times it can be used during a taxpayer’s lifetime.

Gain (or loss) is computed based on the selling price less expenses of the sale and the taxpayer’s adjusted basis in the residence. The adjusted basis is the original cost or, if the taxpayer postponed gain under former IRC Section 1034 when the residence was acquired, the cost adjusted for deferred gain. The cost of improvements (but not repairs or fixing-up expenses) made to the residence increases the taxpayer’s basis, and any depreciation claimed on the property decreases the basis.

To qualify for gain exclusion, the taxpayer generally must own and use the dwelling as his principal residence for a specified length of time. This requirement could preclude many divorcing spouses who have moved out of the home from deferring their share of the gain when the home is ultimately sold. However, a divorced spouse can treat certain periods of occupancy by his former spouse as his own. Thus, the spouse is not penalized for moving out of the marital home, which is a common occurrence during the divorce process. Also, a spouse who receives the home in a divorce-related transfer counts the transferor’s ownership period as his own.

The exclusion for gain on the sale or exchange of a principal residence does not apply if the principal residence was acquired in a like-kind exchange in which any gain was not recognized within the previous five years.

Principal Residence Considerations

Whether a property is used as the taxpayer’s principal residence depends on all the facts and circumstances. For example, a houseboat, a house trailer, or a house or apartment that a taxpayer is entitled to occupy as a tenant-shareholder in a cooperative housing corporation may qualify as a principal residence.

If a taxpayer alternates between two properties using each as a residence for successive periods, the property used the majority of the time during the year ordinarily will be considered the taxpayer’s principal residence. In Guinan, the taxpayer had multiple residences and attempted to use the amount of time spent at a particular residence over five years to determine the principal residence (referring to the two-out-of-five-year use requirement). The court ruled that the test for the majority of the time used as a principal residence is measured over the course of a year, not over a period of years.

Special Rules for Military Members on Extended Duty

Members of the uniformed services, U.S. Foreign Service, or employees of the intelligence community serving on qualified official extended duty may elect to suspend the five-year ownership and use period. The five years may be extended for up to ten years during which the taxpayer or the taxpayer’s spouse is on qualified official extended duty.

To meet the qualified extended duty, the taxpayer (or his or her spouse) must be serving extended duty at a duty station at least 50 miles from the residence or living in government quarters at the government’s order. Extended duty is a period of active duty greater than 90 days (or an indefinite period of duty).

The election can only be applied to one residence at a time, but it can be revoked at any time.

Partial Gain Exclusion

A portion of the gain from the sale of a principal residence can be excluded when the taxpayer fails to meet the requirements (i.e., ownership and use requirements or one-sale-in-two-years requirement) only because of:

• A change of place of employment
• Health reasons
• Unforeseen circumstances, including divorce or legal separation under a divorce decree or separate maintenance agreement

Election to Not Apply Gain Exclusion

Taxpayers can elect to have the gain exclusion rules not apply. If the election is made not to exclude the gain, the taxpayer recognizes any gain realized on the transaction. There may be occasions when the election is beneficial.

Effect of Filing Status on the Exclusion

Qualifying for the Exclusion

Married taxpayers filing a joint return for the year of sale may exclude up to $500,000 of gain if:

• Either spouse owned the home for periods aggregating two years or more during the five-year period ending on the sale date, and
• Both spouses used the home as a principal residence for periods aggregating two years or more during the five-year period ending on the sale date, and
• Neither spouse is ineligible for the exclusion because he or she had sold another home within the two years ending on the sale date to which the exclusion applied.

Entering Marriage with One Spouse Owning a Home

When only one individual entering a marriage owns a principal residence, close attention to the calendar and to usage by the non-owning spouse can make the difference between a completely tax-free gain and a partially taxed gain.

Both Spouses Entering Marriage Owning Homes

Suppose both parties entering a marriage intend to move into a new principal residence after marriage. In that case, each can sell their former residence and each can claim up to a $250,000 exclusion, provided they meet the three qualifications.

The provision limiting the exclusion to only one sale every two years by the taxpayer does not prevent a husband and wife filing a joint return from each excluding up to $250,000 of gain from the sale or exchange of each spouse’s principal residence owned at the time of their marriage, provided each spouse would be permitted to exclude up to $250,000 of gain if they filed separate returns.

Expanding Beyond Real Estate: Other Financial Considerations in Divorce

Division of Retirement Accounts and Pensions

Beyond the family home, retirement accounts and pensions are often the most valuable marital assets. Dividing these requires a Qualified Domestic Relations Order (QDRO). A QDRO is a court order that allows pensions, 401(k) plans, and other retirement plans to be divided without triggering early withdrawal penalties or taxes. Failure to obtain a QDRO or incorrectly drafting one can result in costly mistakes.

Business Interests and Investments

If one or both spouses own a business, valuation becomes a central issue. Courts may order professional appraisals, and the outcome varies depending on whether the business is community property or separate property. Similarly, dividing investment portfolios requires a strategy that considers both tax implications and future growth potential.

Spousal Support and Child-Related Expenses

Recent tax law changes, particularly those enacted after 2019, have altered the treatment of alimony. Alimony is no longer tax-deductible for the payor, nor taxable income for the recipient. Child-related expenses, including health insurance and extracurricular activities, must also be factored into financial planning during divorce.

Debt and Credit Division

Debt can be as impactful as assets. Mortgages, credit cards, student loans, and personal debts must be equitably divided. Courts may assign responsibility, but lenders will still hold both spouses accountable if both names are on the account. Protecting your credit score by closing or refinancing joint accounts is critical.

Estate Planning After Divorce

Once a divorce is finalized, it is essential to revisit estate planning. Wills, trusts, and beneficiary designations on life insurance policies and retirement accounts should be updated to reflect new circumstances. Failure to make these changes can leave former spouses unintentionally benefiting from policies or inheritances.

State Law Differences: Community Property vs. Equitable Distribution

Divorce law varies widely depending on the state. In community property states (like California, Texas, and Arizona), most assets and debts acquired during marriage are divided equally. In equitable distribution states (such as New York or Florida), courts divide property in a way deemed fair but not necessarily equal. These legal frameworks significantly impact how assets, such as homes, pensions, and businesses, are divided.

Understanding whether your state follows community property or equitable distribution principles is essential before making decisions about settlement. Consulting both a divorce attorney and a financial planner helps align expectations with legal realities.

Emotional vs. Financial Decision-Making

Divorce often tempts spouses to make decisions based on emotions rather than financial considerations. For example, a spouse may fight to keep the marital home without realistically considering whether future income can sustain the mortgage, taxes, and upkeep. Others may accept a short-term cash settlement without weighing the long-term benefits of retaining retirement assets.

Emotions are an undeniable part of divorce, but financial clarity ensures long-term stability. Women in particular face unique challenges, including wage gaps, time out of the workforce for childcare, and the risk of financial abuse. Prioritizing financial empowerment and long-term planning creates security for both women and their children.

Role of Professionals in Divorce Financial Planning

Divorce rarely involves just one professional. Attorneys, mediators, forensic accountants, tax advisors, and certified divorce financial analysts often collaborate to craft a settlement that balances legal obligations with financial strategy. Engaging these professionals ensures that tax elections, property divisions, and QDROs are properly executed, reducing the risk of costly mistakes.

Frequently Asked Questions (FAQs)

Can I still claim the home sale exclusion if I move out before the divorce is finalized

Yes, certain periods of occupancy by your former spouse can be treated as your own, allowing you to qualify even if you no longer live in the home.

What happens if my ex-spouse receives the marital home in the divorce?

The transferee spouse can count the transferor’s ownership period toward meeting the two-out-of-five-year requirement.

Do I need a QDRO to divide retirement assets in a divorce?

Yes, a QDRO is required to divide pensions and certain retirement accounts without triggering early withdrawal penalties or taxes.

Is alimony still tax-deductible?

No. Under the Tax Cuts and Jobs Act of 2019, alimony is no longer deductible for the payor or taxable to the recipient for divorces finalized after December 31, 2018.

How can I protect my credit during a divorce?

Close joint accounts, monitor your credit report, and ensure your divorce decree specifies who is responsible for each debt.

How does community property differ from equitable distribution?

In community property states, marital assets and debts are divided equally, while in equitable distribution states, courts divide them fairly but not necessarily equally.

Should I sell my house before or after the divorce?

The answer depends on market conditions, tax considerations, and personal financial circumstances. Consulting with a divorce attorney and financial advisor ensures the timing aligns with your long-term goals.

Get Legal Help

Divorce reshapes both emotional and financial futures. While emotions are inevitable, the financial decisions you make today will define your security for decades. Balancing tax considerations, asset division, retirement planning, and future stability is crucial.

If you are facing divorce and want to ensure your financial interests are protected, consult the experienced family law attorneys at Reape Rickett. From complex property division to long-term financial planning, their team helps clients make informed, strategic decisions that safeguard their future.

Visit Reape Rickett to learn more and schedule a consultation today.