In our previous tax matters article, we discussed a few spousal maintenance issues and the importance of applying for a new social security card if you changed your name in the divorce. Today we’ll discuss some important issues involving the marital residence and taxes.
Capital Gains in a Nutshell.
For many, the concept of a capital gain conjures up visions of million dollar homes sold for even more millions. The Internal Revenue Service is a little more pragmatic in its vision, however. Here are 10 IRS facts about capital gains and losses:
“1. Almost everything you own and use for personal purposes, pleasure or investment is a capital asset.
2. When you sell a capital asset, the difference between the amount you sell it for and your basis — which is usually what you paid for it — is a capital gain or a capital loss.
3. You must report all capital gains.
4. You may deduct capital losses only on investment property, not on property held for personal use.
5. Capital gains and losses are classified as long-term or short-term, depending on how long you hold the property before you sell it. If you hold it more than one year, your capital gain or loss is long-term. If you hold it one year or less, your capital gain or loss is short-term.
6. If you have long-term gains in excess of your long-term losses, you have a net capital gain to the extent your net long-term capital gain is more than your net short-term capital loss, if any.
7. The tax rates that apply to net capital gain are generally lower than the tax rates that apply to other income. For 2009, the maximum capital gains rate for most people is 15%. For lower-income individuals, the rate may be 0% on some or all of the net capital gain. Special types of net capital gain can be taxed at 25% or 28%.
8. If your capital losses exceed your capital gains, the excess can be deducted on your tax return and used to reduce other income, such as wages, up to an annual limit of $3,000, or $1,500 if you are married filing separately.
9. If your total net capital loss is more than the yearly limit on capital loss deductions, you can carry over the unused part to the next year and treat it as if you incurred it in that next year.
10. Capital gains and losses are reported on Schedule D, Capital Gains and Losses, and then transferred to line 13 of Form 1040.”
More often than not, the marital residence is the most valuable asset that a married couple owns. During the divorce, it is not unusual for the marital home to be sold and the proceeds divided and distributed to the parties. If the home was sold for more than it was purchased for, meaning there was a gain on the capital asset, then there are specific rules affecting the spouses’ capital gains tax liability.
Capital Gains Tax and the Principal Residence Rule.
Transfer Between Spouses. In general, if you transfer your interest in the marital home to your spouse, or former spouse as incident to your divorce, you will not have a capital gain or loss. That’s the result even if you received cash or some other property in exchange for your interest in the marital home. (The only exception to the “no gain or loss” in a transfer to a spouse incident to a divorce is if your spouse or former spouse is a nonresident alien, in which case there would be a gain or loss.)
Sale of the Marital Home. One couple’s home is another couple’s castle, or something like that. The point being that the marital “home” could be a house, a houseboat, a mobile home, a cooperative apartment, or a condominium, but generally not vacant land.
When your home is sold and there is a capital gain, can you avoid a capital gains tax? That depends on whether you owned and lived in the home, as your main home and not as a secondary residence, for at least two years in a five-year period that ends on the day the home was sold. This is also known as the principal residence rule for capital gains tax purposes.
Maximum Exclusion. If you satisfy the principal residence rule, then you can exclude up to $250,000 of the gain on the sale of your main home. And if you are married and file a joint tax return, that exclusion could be $500,000 if it was the main home for both spouses, for two years in the five-year period ending on the day of sale ($250,000 for each spouse).
Problems can arise when the marital home isn’t sold to a third party during or shortly after the divorce. For example, assume that after the divorce is final, the home is lived in continuously by one ex-spouse who has primary physical custody of the children. He or she lives there for many years before the home is sold and the proceeds divided. The ex-spouse who resided in the home for two years in the five-year period ending on the date of sale would avoid capital gains tax. The other ex-spouse — who doesn’t satisfy the principal residence rule — would not avoid capital gains tax. This should be sufficient incentive to make sure that you consult with your tax professional whenever you have questions about your personal tax liability, including possible capital gains issues.
Don’t allow yourself to be taken advantage of in your divorce or legal separation. Contact the experienced family law attorneys at the Law Offices of Scott David Stewart today, and protect your financial future.