(This valuable series on Dividing Property In A Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)
III. Section 1041 Specifics as to Type of Property
1. The Marital Residence
Perhaps the most common property division issue the practitioner will face when a couple divorces will be the division of the marital home. Often, which spouse, if any, will end up with the home will be the central issue in the property settlement.
Furthermore, non-monetary issues such as emotional attachments, or the preferred school district for couples who have children, frequently complicate matters.
Given the above, it is imperative that the practitioner be thoroughly familiar with the tax ramifications of dividing the residence.
- A qualifying single taxpayer can exclude up to $250,000 of gain on sale of principle Qualifying married couples filing jointly can exclude up to $500,000.[1]
- Taxpayer must have maintained the home as his/her principal residence for two out of the last five years.[2]
- Taxpayer must have owned the residence for two out of last five years
- Only one sale every two years qualifies for the exclusion. Taxpayer must not have used the exclusion during the previous two-year period before the current sale.[3]
Tax Trap Alert: Practitioners should familiarize themselves with the major exceptions and special cases IRC Section 121 and the related regulations and rulings address, including but not limited to the following:
- Recapture of depreciation if the residence was used for a trade, business, or home office
- Adjustments to basis for deferred gain under former section 1034
- No gain exclusion when there was like kind exchange (IRC Section 1031) with nonrecognition of gain within the past five years.[1]
- Special rules for members of the U.S. Military, Foreign Service,Intelligence Community and/or their spouses.[2]
- Partial gain exclusion in certain cases when taxpayer does not meet principal residence ownership and use tests due to change in location of employment, health, or unforeseen circumstances, including divorce or legal separation.[3]
2.Splitting the Principal Residence in Divorce
In a divorce situation, generally the issue of the marital residence will be settled by either selling the home and splitting the proceeds between the former spouses, or by transferring the entire ownership in the house to one spouse in return for some other asset or cash to equalize the statement.
Selling the residence under the terms of the divorce agreement with proceeds equally divided. Often the residence will be ordered sold as part of the divorce proceedings. Assuming that the home was held in some type of joint ownership or community property, each spouse is considered to have owned half the property. If each spouse in their own right meets the 2 out of the 5-year test, then each spouse would be allowed to exclude up to $250,000 in gain.
Example: Ozzie and Harriet are divorcing and are filing their tax returns as married filed separately. Their principle residence has a basis of 400,000 and is sold for $1,000,000. The home is held as community property. Assuming they otherwise qualify for the Section 121 exclusion, each of them can exclude $250,000 of the $600,000 gain on the sale of the home. The remaining $100,000 of unexcluded gain would be split between them equally so they would each report a $50,000 taxable capital gain as follows:
Basis……………………………. $400,000
Sales Proceeds……………… $1,000,000 __________________________________
Gain………………………………$600,000
Section 121 Exclusion (Combined)……………<$500,000>
Net Gain………………………… $100,000
Net Gain Reported by Each Spouse……………. $50,000
b) Selling the residence under the terms of the divorce agreement with the proceeds divided unequally. Circumstances may arise such that even though the marital home is held in joint ownership, the proceeds from its sale may be unequally divided. In this situation, it is generally agreed that each spouse has sold one half of the house, and then one spouse has subsequently transferred some of his/her proceeds to the other spouse. Each spouse would therefore recognize 50 percent of the gain as in the previous example. The transferred funds between spouses would not be subject to tax assuming that they otherwise qualified under IRC Section 1041. Another approach would be to transmute the spouses’ ownership interest in the home in proportion to the desired ratio by which the proceeds are to be split. In other words, if Spouse A is to receive 60% of the proceeds, then Spouse A shall be responsible for picking up 60% of the taxable gain on the sale of the residence.
Tax Trap Alert: Practitioners should exercise caution concerning transmutation of property from one spouse to the other. State law varies considerably on this issue and it may be necessary to consult legal counsel.
c)Transfer of residence from one spouse to the other. IRC Section 1041 governs the transfer of property between spouses in marriage and divorce
1.Neither spouse recognizes gain or loss.[1]
2.The receiving spouse’s basis is his/her basis plus the basis of the transferee [2]
Example: Assume Lucy and Ricky purchased their home during their marriage for $450,000 and made improvements of $150,000. The home is jointly held. Ricky transfers his share of the home ownership to Lucy. Lucy’s basis in the home thus becomes $600,000 ($450,000 + $150,000 =$600,000)
3.Only one spouse must meet ownership test to exclude gain. When one spouse transfers ownership to the other, the ownership period of the home of the transferor may be attributed to the transferee for purposes of gain exclusion.[3]
Example: Fred and Wilma live in a house that Fred has owned as a separate property for the past 10 years. They have used the home for the past 3 years as their principle residence. As part of their divorce settlement, Fred transfers ownership of the home to Wilma. For purposes of the Section 121 gain exclusion, Wilma meets both the ownership and use test since Fred’s ownership period transfers to Wilma, and she has used as the home as her principle residence for 2 out of the past 5 years. Were Wilma to sell the house post divorce as a single person, she could exclude up to $250,000 of gain.
d)Postponed sale of residence with only one spouse living in residence. Use period of spouse living in residence can be attributed to spouse residing elsewhere.[1]
Example: Barney and Betty jointly own and reside in their residence for 10 years prior to their divorce. Under the terms of their divorce agreement, Betty is to remain in the house for another 5 years until their youngest child finishes high school. At that time, the house is to be sold and the proceeds equally divided. Barney will not reside in the home post-divorce. For the purposes of the gain exclusion, both Betty and Barney can each exclude up to $250,000. Barney is considered to be using the home as his principle residence even though he is not living there. He thus meets both the ownership and use test for the purposes of IRC Section 121.
e)Mortgage Interest and Real Estate Taxes. An issue that practitioners frequently face in divorce situations is allocating the deduction between spouses for mortgage interest and taxes when one spouse has moved out of the residence and separate returns are being filed.
(Series To Be Continued In Dividing Property In Divorce Tax Traps – Part 4)
Have a question? Contact David Ellis, Ellis & Ellis CPAs.
(All footnotes will be posted at end of series! This material is for informational purposes only and is not a substitute for tax advice from a qualified professional and the author assumes no liability whatsoever in connection with its use. No advisor/client relationship exists.)
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