When couples are divorcing, it often occurs that the residence is one of the most valuable assets to divide, and as a result, needs to be sold in order to equitably divide the assets between each party. Typically, a federal income tax exclusion is available to offset some or all of the gain on the house. However, depending on how the divorce is structured, one of the parties could forfeit their portion of the exclusion resulting in a surprise from the IRS.
The IRS permits up to $250,000 exclusion for a single person. A married jointly-filing couple can exclude up to $500,000. If the home sale occurs prior to entry of the divorce and the couple is divorced that same year, the issues are usually fairly easy to deal with. They can jointly file their tax return, or file separately and each claim their half of the exclusion.
However, if the sale will occur after the divorce is finalized, things get more complex. At least one party will be required to remain residing in the property for two out of the last five years before the house is sold.
Importantly, the non-resident party must have specific language drafted into their divorce paperwork to preserve his/her “use” of the property. This language will give credit to the non-resident spouse for use of the property as a principal residence and thus permit him/her to qualify for the $250,000 exclusion.
Keep in mind that facts in a particular divorce case vary greatly and there exist other requirements to fully comply with the IRS regulations regarding gain exclusion. If you are in the difficult position of seeking a divorce, speak with a knowledgeable attorney and tax professional to fully protect your rights and minimize the tax consequence of a divorce settlement.