Consider the Tax Consequences of Selling a Home During Divorce

The tax collector looks over the shoulders of couples who are divorcing. Usually the individuals are thinking about what to do with the house, and don’t even suspect there might be a tax question. All they remember is the rule that capital gains taxes can be postponed and often avoided forever when people move from one home to another.

Poor planning and bad timing, however, can give the IRS a chance to pounce and collect taxes that are normally out of reach. The tax collector is going to ask when the house was sold, who moved out before the sale, what the individuals later bought, and when these events happened.

For instance, suppose the husband moves out and the divorce becomes final a year and a half later. Suppose further the ex-wife gets to live in the house for another two years, then sells. The husband assumes he can buy another home that’s worth at least half the value of his former home, so he defers his half of the gain from the later sale into the basis of his new home.

“Wait a minute,” the tax collector says. “You can only defer the tax on the gain from the sale of a principal residence. You moved out years before the sale. You weren’t living there. That’s not your principal residence, so you can’t defer the tax on the gain. You owe the tax on your half of the gain.”

Try another example. You sell the home and report the gain from the sale on a joint tax return. You say you intend to defer the tax on the gain by replacing the home with a new principal residence. The following year you get divorced. You later buy a home that’s worth half as much as the home you just sold. The partner can’t afford to buy, so she rents.

She’s stuck with the gain on her half of the sale. Remember why she didn’t buy: she couldn’t afford to. So maybe she also can’t afford to pay her share of the tax due from the sale of the house. Do you care?

You should care. “Remember the joint return you filed?” the tax collector asks. “On a joint return both of you are jointly and severally liable for any tax deficiency. Since she can’t pay, you must. If you don’t, we’ll just levy your salary until we get what we want.”

The unsettling part is that these are avoidable taxes. Better planning might enable both partners to move into other houses with no capital gains tax liabilities. This sets the stage for them to continue deferring gain on later sales until age 55, when as much as $150,000 of gain is sheltered forever.

Planning and good faith negotiation aren’t always characteristics of divorces, unfortunately. Consider the wife who moves out and wants to sell the house and defer the gain into another house she wants to buy. The husband won’t move, won’t put the house on the market. Or, if he does market the property he prices it unrealistically so it won’t sell.

Does this mean the tax collector will tell her she can’t defer her half of the gain because she’s abandoned the house as a principal residence? No, says the tax court. She can defer her half of the gain when the husband comes to his senses and the house eventually sells. His lack of cooperation doesn’t deprive her of this tax benefit.

There are several ways to avoid depriving one party from deferring gain, or getting stuck with the bill for the ex-spouse’s tax. One is the return where married file separately. This divides things up in a way that solves some of these problems. Since other taxes may be higher, however, separate filing may be unwise for that reason.

Separate returns only work if the couple has not earlier filed a joint return: you can’t amend and change a married return to married filing separately. “This decision depends on the scenario each partner has for buying other homes,” says Mark Schneiter, an Anchorage CPA.

Another way to avoid the charge of having abandoned the residence is to arrange for the divorce decree to forbid a sale for some time. This sometimes happens when one spouse wants the right to stay in the property while children are finishing a school year. Since a sale has been barred by court order, the absent spouse will probably be allowed to defer the gain when the sale eventually happens.

Turning the house over to your spouse in the property settlement avoids getting stuck with your ex-spouse’s tax bill. When your spouse has the property and therefore the entire basis, the spouse is liable for all the tax on the gain, also having the opportunity to defer all the gain. This may not be feasible, of course, if there aren’t enough other assets to balance the equity in the home you would give up.

Tax court rulings and tax law changes by Congress make a moving target of answers to these complex questions. Be sure the tax and legal advisors you employ are competent in real estate taxation, as well as divorce law.