The Capital Gains Exclusion & Selling the Marital Home
Buying a new home is an exciting new beginning for married couples. When the time comes to sell the home, the 4Sale sign may not be under such happy circumstances.
When the sale of the marital home comes with potential Capital Gains Taxes, it is important to have an understanding of the available exclusion tests. In general, to qualify for the Section 121 exclusion, both the ownership and the use tests must be met.
Current Capital Gains Exclusion on the sale of the primary residence currently allows for a $250,000 individual exclusion and a $500,000 marital exclusion.
Ownership & Use Rules
Ownership Rule | In order to meet the ownership rule for the capital gains exclusion on the sale of the marital home, individual ownership must exist for the individual exclusion or joint ownership must exist for use of the marital exclusion.
Ownership may be established in two ways. Legal ownership in the property may be established when one or both parties have vested ownership as evidenced by each holding title to the property. Ownership may be held individually or jointly in various ways.
Ownership in the marital home may also be established through legal marriage. For a married couple filing jointly, only one spouse has to meet the ownership requirement. This may increase the total exclusion available to $750,000 if one of the divorcing spouses remarries and the new spouse lives in the home for 2 out of the previous 5 years prior to sale.
Important Note: When a future sale of the marital home is expected and the marital exclusion will be needed, both spouses must stay on title once the divorce is final. Once the chain of ownership is broken, the divorcing couples may no longer qualify for the marital exclusion.
Ownership & Use Test
Residence Use Test | In order to meet the Residence Use Test, each party must have used the home as their primary residence for at least 24 months of the previous 5 years. You must have lived in the home for 2 of the last 5 years as your primary residence. The 24 months of residence can fall anywhere within the 5-year period, and it doesn’t have to be a single block of time. All that is required is a total of 24 months (730 days) of residence during the 5-year period. Unlike the ownership requirement, each spouse must meet the residence requirement individually for a married couple filing jointly to get the full exclusion.
The vacating spouse may still meet the Residence Use Test even if they do not meet the standard use test of having lived in the marital home for 2 of the previous 5 years prior to sale as long as:
• The vacating spouse retains ownership either solely or jointly, and
• The former spouse continues to live in the home under a divorce or separation agreement and uses the home as his or her main home.
If ownership in the home is transferred to one spouse without legal ownership via title vesting, ownership in the home may be counted for any time when the other spouse owned the home as time owned. However, each spouse must meet the residence use requirement on their own.
The Ownership and Use Tests may be met during different 2-year periods. However, both tests must be met during the 5-year period ending on the date of the sale. Generally, a person is not eligible for the exclusion if they excluded the gain from the sale of another home during the two-year period prior to the sale of the primary home.
Partial Exclusion of Gain for Divorcing Couples
When divorcing couples don’t meet the Eligibility Test for the Ownership and Use periods, they may still qualify for a partial exclusion of the gain. The IRS recognizes couples who become divorced or legally separated as an unforeseeable event and will allow a partial exclusion of the gain.
Example | Mike and Kim purchase a new home in July of 2017 for $400,000. In January of 2019, they are getting a divorce and must sell the marital home. Current market value is $550,000. After the cost of selling the home, they will have a Capital Gain of $125,000.
The standard rule for using the capital gains exclusion requires that Mike and Kim must have lived in the home for 2 of the last 5 years; however, in their case, they have only lived in the home for 18 months. Mike and Kim may use a prorated capital gains exclusion equivalent to 18/24 or 75% of the available exclusion amount. It is recommended that they speak with a tax accountant to verify their prorated exclusion.
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