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
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.
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.
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
- 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.
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
- 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
Home improvements that increase your home's
Extra bedroom, bathroom, deck, porch, garage, patio, fireplace
Lawn and grounds
Landscaping, driveway, walkway, fences, pool
Satellite dish, intercom system, security system
Heating and air conditioning
Lighting fixtures, wiring upgrades
Attic, walls, floors, pipes
Built-in appliances, kitchen or bath modernization, flooring,
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.
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