GPSolo Magazine - September 2005
The Marital Residence: Who Benefits from the Sale and Deductions?
A family residence is involved in almost every divorce, regardless of whether the parties have accumulated a substantial estate or a modest one. Tax considerations regarding the residence center principally on (1) sale of the home and (2) deduction of mortgage interest and real estate taxes.
In general, § 121 of the Internal Revenue Code provides for the exclusion of up to $250,000 of gain—$500,00 for married taxpayers satisfying the requirements summarized below—on the sale of a home owned and used as a principal residence by the taxpayer for two of the five years preceding the date of sale.
Married taxpayers qualify for the $500,000 exclusion under the following conditions:
- The parties file a joint return for the year of sale.
- At least one spouse satisfies the two-out-of-five-years ownership requirement.
- Both spouses satisfy the two-out-of-five-years use requirement.
- Neither spouse is ineligible because he or she used the exclusion in conjunction with a previous sale within two years of the date of the current sale.
Although the exclusion generally is not available to a taxpayer who has claimed such an exclusion during the preceding two years, if his or her failure to satisfy the two-years requirement results from a change of employment, health problems, or other unforeseen circumstances, a percentage of the $250,000 is allowed, equal to the percentage of the two years the ownership and use requirements were met. For example, a taxpayer lived in a home for six months, at which point he sold it and moved to accommodate a job transfer. Because 25 percent of the two-out-of-five-years requirement was satisfied, 25 percent of the $250,000/$500,000—or $62,500 for a single taxpayer and $125,000 for married taxpayers—would be available.
The IRS issued regulations for I.R.C. § 121 in 2002. They provide more detail regarding circumstances under which a taxpayer is entitled to a prorated exclusion. Of particular relevance is inclusion of a sale resulting from a divorce or legal separation as a “safe harbor” event in the “unforeseen circumstances” category. Thus, if the sale of the residence in the example resulted from a divorce, 25 percent of the exclusion would be available, as if the sale resulted from a change in employment or health problems. Although the “safe harbor” list does not include an annulment or de facto separation, such an event would likely qualify under the “unforeseen circumstances” criteria.
Pertinent rules. The regulations illustrate application of the exclusion (1) when an unmarried couple sells a home they have been living in and (2) when newlyweds sell the homes each had lived in prior to the marriage.
As for unmarried cohabitants, assume A and B have jointly owned and used their home as a principal residence for the last seven years. They are now selling the home at a gain of $256,000. A and B are unmarried at the time of the sale. Because each satisfied the two-out-of-five-years ownership and use requirements, each is entitled to a $250,000 exclusion, which is more than adequate to shelter their respective $128,000 or 50 percent share of the gain. It does not matter whether A and B were ever married or were divorced before the sale.
As for newlyweds, assume A and B plan to buy a new home together and sell the homes each lived in prior to the marriage. Neither party satisfies the ownership and use requirements with respect to the other’s premarital home. A and B have gains of $200,000 and $300,000, respectively, incident to the sales. Whether they file jointly or individually, A’s $200,000 will be fully excluded by the $250,000 exclusion, whereas $50,000 of B’s gain—the excess over the $250,000—will be subject to tax. B may not use A’s unused exclusion on B’s gain in excess of the $250,000 limit.
If a single taxpayer who otherwise qualifies for the exclusion marries a new spouse who has used the exclusion within the two-year period, the newly married taxpayer’s exclusion is limited to $250,000. To qualify for a $500,000 exclusion, the taxpayer’s new spouse must occupy the home for two years, and two years must have elapsed since either party previously used the exclusion.
For purposes of the two-out-of-five-years ownership requirement, a spouse who acquires an interest in a principal residence from a spouse or former spouse incident to a divorce settlement is considered to have owned the residence or the interest in the residence for as long as it was owned by the transferor spouse. Further, use by one spouse or former spouse, specifically provided for in the divorce settlement, is attributed to the other spouse.
The marital status on the date of sale is used to determine whether the available exclusion is $250,000 or $500,000. However, even if parties are married on the date of sale, to qualify for the $500,000 exclusion they must satisfy the three other requirements noted above, including filing a joint return for the year of sale. Thus, they will not qualify if divorced after the sale but before December 31 of the same year.
Mortgage interest and taxes. General rules regarding deduction of mortgage interest and real estate taxes on a jointly owned principal residence are based largely on IRS rulings and case law.
In the case of a joint tenancy with survivorship rights, the joint owner who makes the payment is entitled to the deduction. If spouses own a home as tenants in common, the payer of mortgage interest and real estate taxes may deduct them only to the extent of his or her interest—usually 50 percent.
Payments made in a divorce context. The deductibility of mortgage interest, property taxes, utilities, maintenance, etc., in a divorce context depend on: (1) ownership of the home; (2) use of the home as a personal residence; (3) liability on the mortgage loan; and (4) whether payments are pursuant to a divorce or separation instrument.
The tax treatment of mortgage interest and real property taxes related to a home in common situations following a divorce is based on the following assumptions:
- The husband is the payer of all expenses pursuant to the governing divorce document.
- The wife is living in the former marital residence with the parties’ child.
- The husband has selected the former marital residence as an “other residence” for purposes of deducting mortgage interest.
If the husband and wife are tenants in common and jointly obligated on the mortgage loan, then half the payments are taxable/deductible as alimony, and the husband and wife are each entitled to deduct half the mortgage interest and real estate taxes as itemized deductions.
If the home is solely owned by the wife, and if she and the husband are both liable on the mortgage loan, then half the mortgage interest and all the real estate taxes are taxable/deductible alimony, the husband and wife are each entitled to deduct half the mortgage interest, and the wife may deduct all the real estate taxes.
If the wife is the sole owner of the home and is solely obligated on the mortgage loan, then all payments are taxable/deductible alimony, and the wife may deduct all mortgage interest and real estate taxes.
Joseph W. Cunningham, JD, CPA, is a litigation valuation services partner with Plante & Moran, PLLC in Southfield, Michigan. He can be reached at email@example.com .
For More Information About the Section of Family Law
- This article is an abridged and edited version of one that originally appeared on page 18 of Family Advocate, Winter 2005 (27:3).
- For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221.
- Website: www.abanet.org/family.
- Periodicals: Family Advocate, 64-page quarterly magazine; Family Law Quarterly, quarterly journal.
- Books and Other Recent Publications: Collaborative Law; The Complete QDRO Handbook; The Divorce Trial Manual; 101+ Practical Solutions for the Family Lawyer; Balancing Competing Interests in Family Law; Frequently Asked Questions About Divorce: A Client Manual.