Divorce Tax Law and Property
In this tax tip article, we look at the sale or transfer of a house due to a court ordered decree of divorce or separation instrument.
The costs of selling real estate are considerable. Real estate commissions, closing costs, and fees can be many thousands of dollars. The selling process can also be extremely time consuming. The advantage is that real property, meaning land and houses, qualify for special rules of property transfers.
If the house is transferred to a former spouse as the result of a divorce, then the nonrecognition property transfer rules can apply. This means that the former spouse will own the house and no taxes are liable to either party.
Selling the house
There are times when selling the house is the best option for both parties. It provides cash and allows both spouses to live in new communities. Section 121 of the tax code allows a person to exclude from income up to $250,000 of gain on the sale of their primary house. If both parties have lived in the house for two of the past five years, both parties may be able to exclude $500,000 of gain, or $250,000 for each spouse in their income tax. Because of that, the sale of a house may be largely tax free. It is important to note, however, that vacation homes don’t qualify for this divorce law exception. The IRS only applies this for the primary home.
For example:
A married couple in Duarte jointly owns a house worth $700,000 with a mortgage of $100,000. As a result of a divorce, one spouse is required to transfer their interest in the house to the former spouse. This means that one spouse surrenders their $300,000 share, or his/her half of the $600,000 of equity in the house to their former spouse, and will have no tax due on this transfer. The former spouse thus receives $600,000 of equity and no taxes are due until the house is sold.
However, if the house in Duarte is sold for $700,000—(we’ll ignore the commissions and closing costs to keep it simple)—each spouse will receive $300,000 after paying off the $100,000 mortgage. Up to $250,000 of that gain per spouse can be excluded from income. Therefore, $50,000 is taxed at the appropriate capital gains rate of 15%, yielding a tax of $7,500 for each spouse. Each spouse will net $292,500 and the total cash payment made to former spouse will be $585,000. Notice that the sale of the house provides $15,000 less to the former spouse due to taxes, and presents a tax bill of $7,500 to the spouse surrendering their interest in the house. The real amount provided to the former spouse will be even less once commission and selling costs are included.
MiklosCPA can help you determine the best way to divide assets while minimizing your tax liability while going through a divorce. Divorce law is no simple matter. If you find our free tax resources useful, please share it and connect with us on our social media pages.