Early in this writer’s career lawyers used to have to be careful about possible capital gains tax on the sale of a personal residence. Before 1997 the exclusion was $125,000 per spouse and $250,000 if the taxpayers filed jointly. In 1997 Congress doubled the exclusion to $250,000 and $500,000 for joint filers.
That was a big exclusion; then. It doesn’t look so big now and in our modern world, you and your soon to be ex may want to think about that before closing out your separation with a decree of divorce. Because, to claim the $500,000 exclusion you need to be married in the year when the house is sold and that means married on December 31 of that year. Should your decree become final a day, week or month earlier than December 31, the exclusion is capped at $250,000.
So, what does this mean in practical terms? I buy my house in 1992 and I pay $200,000. In 2024 spouse and I are wrapping up our divorce. The house is worth $600,000 which means after commissions and taxes the net sale on which tax may fall due is roughly $300,000. If we file jointly for tax year 2024 (which is to say in April 2025) no worries because we jointly have a $500,000 exclusion and even lawyers understand that $300,000 is less than the $500,000 exclusion.
But we are both impatient and our families are anxious to see the conflict concluded. So, we divorce now and then sell the house. That’s not a problem because if we sell the house jointly even though we don’t file jointly each of us will claim half the sales price net of sale costs ($550,000/2= $275,000) and then claim half of our $200,000 basis. That makes for a gain of $175,000 each, still within the $250,000 we are each allowed to exclude on a primary residence. $275,000 minus $100,000 yields a $175,000 gain on each of our returns and that is blessedly less than the $250,000 exclusion we have when filing as individuals. Note that in the capital gains world the amount you paid off on sale to retire your mortgages is not relevant to the calculation.
The problem emerges when the divorce is processed and the parties have agreed that one of them will take the house. Under Section 1041 of the Internal Revenue Code, the person getting the property in a divorce gets what is called a “carryover basis”; the basis from when the house was first acquired. Now that person is single and his/her $350,000 gain is protected by a single person’s $250,000 exclusion. That yields a $100,000 gain on the sale that is taxable at federal rates that can be 15-20% depending on your other income. In real terms it means that up to $15,000 to $20,000 of the proceeds will have to be paid to Uncle Sam in addition to the 2.8% Pennsylvania will snag without any exclusion. That’s another $9,800 in state tax because there is no exclusion on the $350,000 in gain.
As we said at the outset, real estate prices did climb through the 1990s and 2000s but homes in the $300-700,000 range have taken off in value since 2019. This also seems to be true with seashore properties of all kinds in recent years.
If you are the spouse who will be “getting” the appreciated home in a divorce, just make certain that someone does a calculation of what capital gains tax may be baked into your home’s increased value while you held it. That gain can be offset by capital improvements to the property (e.g., pool, new garage, re-construction) but repairs (paint, replaced roof etc) are not counted. IRS Publication 530 is the source for those distinctions. Realize as well that if you operated a business out of the house and decided you wanted to deduct a portion of the household expenses for the portion occupied by your business as depreciation, those deductions may get added back when you sell the house. Lots of people took the “home office” route during the pandemic but most did not realize that yesterday’s deduction could be tomorrow’s income when you are selling. And in cases where there has been a home office for years, the potential recapture of those deductions can be big.
When I circled back to review some of the regulations governing the tax aspects of these transactions, it became clear that this 700 word analysis is “superficial” at best. Suffice to say, if you perceive that you are getting a property or selling a property with more than a $250,000 gain, you need to convey that to both your lawyer and your tax adviser and see how they analyze the tax consequences of sale or transfer. When you do that make certain you collect data on the purchase price and capital improvements or deductions taken during your ownership. Otherwise your advisers will be left to guess; never a good method.
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