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Divorce and home sale gains

As newly divorced taxpayers prepare for next year's tax season, they must consider how the change in their marital status will affect their tax bill. This tax tip explains how a divorce could generate a capital gains tax, as well as legislative changes that have made this less likely. Learn how to compute your home's basis and record any changes that occur. An accompanying tax tip explains how divorce may impose changes in your filing status and eligibility for the child and dependent care tax credit.

Capital gains surprises
So, your spouse packed up bags and left. Besides the emotional upheaval, you also may need to prepare for additional work on your tax return. Couples often sell their home after dissolving the marriage. The loss of a tax deduction and a big tax on the sale may be the result.

How can you prevent tax disasters after a spouse moves out? A common solution is that one spouse "buys out" the other. Capital gains taxes aren't owed when property is exchanged between spouses, meaning the spouse who is "paid off" gets his or her money tax-free. But there is a potential drawback for the spouse who keeps the house. The "in-spouse" will retain the original cost basis along with a possible capital gains tax if the house is sold at a future date.

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How does retaining the original cost basis increase your home's potential capital gain? If you bought or built your home, the amount you paid for it determines your basis. This includes most settlement or closing costs you paid when you bought it and any debt you assumed. If you built your home, your basis includes the settlement or closing costs of both acquiring your lot and securing your mortgage. Your capital gain from selling the home will be the difference between its selling price and the original basis. This could be substantial if the original cost basis is considerably less than its current market value.

Taxpayer Relief Act
Don't panic, though. There is a good chance you won't owe federal taxes on any capital gain from selling your home, thanks to the Taxpayer Relief Act of 1997. The new laws apply for home sales after May 6, 1997. Under the new rules, if you sell a house that was used as a principal residence for at least two of the five years before the sale, you may immediately exclude up to $250,000.

How does this exclusion make the new rules different from the old rules?

  • The exclusion is available to all taxpayers regardless of age. Under the old rules, taxpayers were required to be 55 years of age or older to be able to exclude $125,000.
  • The exclusion can be used repeatedly for subsequent residence sales, as long as it isn't used more than once every two years. Under the old rules, the $125,000 exclusion for those 55 and older could only be used one time.
  • The taxpayer isn't required to buy a replacement home. Under the old rules, the new home had to be at least as expensive as the most expensive previous residence.

How does this compare to the tax liability of the in-spouse before the legislative change? Under the old rules, the in-spouse had to buy a new home years that was worth at least the entire sale price of the family home within two years. If he or she paid less, tax was owed on the difference.

For more information concerning the tax consequences of a home sale, you should consult IRS Publication 523: Selling Your Home.

Increase the basis
What if the in-spouse knows the capital gain on the home will exceed $250,000? Don't despair. There are ways to avoid incurring a substantial capital gain other than selling your home at a price that is too low. Consider past and possible future increases in the basis. Home improvements are the most common increase that occurs to a home's basis. An improvement must accomplish one of the following three goals:

  • Materially add to the value of your home,
  • Considerably prolong its useful life, or
  • Adapt it to new uses.

The following table contains some common examples of improvements:

Home improvements that increase your home's basis

Examples

Additions

Extra bedroom, bathroom, deck, porch, garage, patio, fireplace

Lawn and grounds

Landscaping, driveway, walkway, fences, pool

Communications

Satellite dish, intercom system, security system

Heating and air conditioning

 

Electrical

Lighting fixtures, wiring upgrades

Plumbing

Water heater

Insulation

Attic, walls, floors, pipes

Interior improvements

Built-in appliances, kitchen or bath modernization, flooring, wall-to-wall carpeting

Miscellaneous

Storm windows and doors, roof

There are two other important details about improvements an in-spouse should remember when calculating the home's basis. First, any improvement must remain with the home when it is sold. The same expense can't be claimed twice. For example, if you replace a water heater more than once, you may only add the cost of the latest expenditure to basis.

You also have to distinguish between an improvement and a repair. A repair merely keeps your home in an ordinary and efficient operating condition. It doesn't add to the value of your home, prolong its life or adapt it to a new use. Bottom line? You can't add the repair cost to your home's basis.

The in-spouse can also "carefully time" repairs so that the IRS will accept them as a home improvement. Repairs completed as part of an extensive remodeling or restoration of your home are considered improvements. This means you can add them to your basis. Also, it isn't always easy to distinguish an improvement from a repair. For example, painting either a room or your entire house for the first time is an improvement. You can add the cost to the basis. A later repainting of the room or entire house is a repair, and this cost doesn't increase your basis.

Are you willing to go to some trouble today to minimize your gain when you do sell your home? A change in marital status can make it tough to stay organized. Bite the bullet and take the time to set up a filing system now so that you can keep track of any factors affecting your home's basis. If you bought the home, keep the settlement statement. You'll need objective evidence as well if you have acquired your home by gift, inheritance or divorce. Make sure you hang on to receipts, canceled checks, and other records for all basis adjustments, especially improvements.

Keep these records as long as you own the home. After you sell the home, keep the records for three years after you file your tax returns for the year of the sale. The period of limitations, which is the period in which the IRS can take action against that particular year's return, expires after three years.

Conclusion
If the divorce process wasn't painful enough, preparing for next year's tax season should be. Don't be caught off-guard by the effect your change in marital status will have on your taxes. This tax tip clarifies how you could incur a capital gains tax after a divorce, as well as legislative changes that have made this less likely. Find out how to properly compute your home's basis and record any changes that occur. Another tax tip explains how divorce may impose possible changes in your filing status and eligibility for the child care tax credit.

 

--Posted Oct. 29, 1999

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