Excluding Gain On The Sale Of A Principal Residence

Divorce Think Financially Not Emotionally – Jeffrey A Landers

Divorce is an emotional rollercoaster. And if you’re a woman who’s going through or about to go through a divorce, 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. If one is in the early stages of divorce, it may be a mixed bag of emotions -anger, betrayal, loss, shock, numbness, confusion, panic etc., which may lead to not think 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 frequently is one of the most valuable assets a couple owns, monetary and tax considerations related to dividing the residence usually are very important to a divorcing couple.

Taxpayers may exclude up to $250,000 ($500,000, if married filing jointly) of realized gain on a sale of a principal residence, but generally it 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. Adjusted basis is original cost or, if the taxpayer postponed gain under former IRC Sec. 1034 when the residence was acquired, 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 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 common in a divorce. Also, a spouse who receives the home in a divorce-related transfer counts the transferor’s ownership period as his own. This helps a transferee meet the requirements for excluding gain when the transferor owned the home as his separate property.

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

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 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 a five-year period 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 time used as a principal residence is measured over the course of a year, not over a period of years, citing the previously mentioned regulation in its reasoning.

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 the use period. The five-year period may be extended for up to ten years during which the taxpayer or 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 apply to one residence at a time, but an election 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. a change of place of employment,

b. health, or

c. 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 to not 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 —

a. either spouse owned the home for periods aggregating two years or more during the five-year period ending on the sale date, and

b. 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

c. neither spouse is ineligible for the exclusion because he or she had sold another home within the two-year period ending on the sale date to which the exclusion applied.

Entering the 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 partially taxed gain.

Both Spouses Entering the Marriage Owning Homes

If both parties entering a marriage intend to move into a new principal residence after marriage, each can sell his or her former residence and each can claim an up to $250,000 exclusion, if they each 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.

Disclaimer: This is designed to provide accurate and authoritative information in regard to the subject matter covered. It is with the understanding that the author is not engaged in rendering legal, accounting or other professional services. If legal advice or other expert assistance is required, the services of a professional person should be sought.