The process of divorce involves many significant financial decisions, and one of the most substantial assets to consider is the marital home. When a couple decides to sell their marital home as part of the divorce settlement, various tax implications come into play. It is crucial for divorcing couples to understand these tax implications to make informed decisions and avoid unexpected tax burdens.
First and foremost, let's understand what we mean by the marital home. A marital home refers to the property where a married couple resides during their marriage. It is the primary residence shared by the spouses and is typically owned jointly or in some cases, owned by one spouse with the other spouse having a legal right to it, such as through a marital property agreement.
The marital home can take various forms, including a house, apartment, condominium, or any other type of residential property. It is often a place that holds emotional significance for the couple as it represents their shared life together. In the context of divorce, the marital home becomes an important asset subject to division between the spouses. Decisions regarding the sale, retention, or transfer of the marital home are typically addressed during divorce proceedings, considering factors such as financial considerations, child custody arrangements, and individual preferences.
Tax Implications of Selling the Marital Home
Capital Gain Tax
When selling the marital home, one of the primary tax concerns is capital gains tax. Capital gains tax is the tax paid on the profit made from the sale of a capital asset. In the case of the marital home, the capital gain is the difference between the sale price and the adjusted basis. The adjusted basis is the original cost of the property plus any improvements or renovations made during the ownership period. For example, if the couple purchased the marital home for $300,000 and made $50,000 worth of improvements during their ownership period, the adjusted basis would be $350,000.
If the couple sells the marital home for more than the adjusted basis, then they have a capital gain. If they sell it for less than the adjusted basis, then they have a capital loss. The capital gain is subject to capital gains tax. If the couple files their taxes jointly, they can exclude up to $500,000 in capital gains from the sale of the marital home if they meet the following criteria:
They must have owned and lived in the home as their primary residence for at least two of the five years before the sale.
They must not have excluded capital gains from the sale of another home in the two years before the sale.
If the couple does not meet the above criteria, they can still exclude up to $250,000 in capital gains from the sale of the marital home if they file their taxes jointly. If they file separately, each spouse can only exclude up to $125,000 in capital gains. However, for homeowners, there are certain provisions that can help mitigate or eliminate this tax liability.
a. Primary Residence Exclusion: The Internal Revenue Service (IRS) provides a significant tax benefit for homeowners who sell their primary residence. If the homeowners have lived in the property for at least two of the last five years before the sale, they may qualify for the primary residence exclusion. Under this exclusion, up to $250,000 in capital gains ($500,000 for married couples filing jointly) can be excluded from taxation.
b. Partial Exclusion: In situations where the homeowners do not meet the two-year residency requirement, they may still qualify for a partial exclusion in certain circumstances. These include changes in employment, health issues, or unforeseen events such as divorce. However, the amount of the exclusion will be prorated based on the portion of the two-year requirement fulfilled.
Transfer tax is a tax paid when transferring ownership of a property. In some states, transfer tax is also called a conveyance tax or a deed tax. The transfer tax rate varies from state to state and can range from 0.01% to 4% of the sale price.
If the couple sells the marital home during a divorce, they may be exempt from transfer tax in some states. In some states, transfer tax exemptions are available for transfers of property between spouses during a divorce. It's essential to check the state laws to see if a transfer tax exemption is available.
Mortgage Debt Forgiveness
When a couple sells their marital home, they may have mortgage debt that exceeds the sale price. If the lender forgives the excess mortgage debt, the couple may be subject to income tax on the forgiven debt.
The Mortgage Forgiveness Debt Relief Act of 2007 provides relief to homeowners who have mortgage debt forgiven by their lender. Under this act, mortgage debt forgiven on a primary residence is not taxable as income. The Mortgage Forgiveness Debt Relief Act of 2007 expired on December 31, 2020. However, the Consolidated Appropriations Act, 2021, extended the exclusion for another year, through December 31, 2021.
It's unclear if the exclusion will be extended again in the future. If the couple sells their marital home after December 31, 2021, and the forgiven mortgage debt is taxable, they may be subject to income tax on the forgiven amount.
Division of Proceeds
During a divorce, the proceeds from the sale of the marital home are often divided between the spouses. The division of proceeds may have tax implications depending on the specific circumstances. If the couple files their taxes jointly, they can both take advantage of the capital gains exclusion mentioned earlier. However, if they file separately, each spouse can only exclude up to $125,000 in capital gains. It's important to consult with a tax professional to understand the tax implications of dividing the proceeds from the sale of the marital home based on your specific situation.
Timing and Filing Status
The timing of the sale of the marital home can also impact the tax implications. If the couple sells the home before the divorce is finalized, they can still file their taxes jointly and take advantage of the higher capital gains exclusion. However, if the sale occurs after the divorce is finalized, the couple will have to file their taxes separately and may have lower capital gains exclusion limits. It's crucial to coordinate the sale of the marital home with the divorce proceedings and consult with a tax professional to determine the most advantageous timing and filing status.
Gift Tax Considerations
If one spouse is transferring ownership of the marital home to the other spouse as part of a divorce settlement or agreement, gift tax implications may arise. The transfer may be subject to gift tax rules if it exceeds the annual gift tax exclusion (which is $15,000 per recipient as of 2021) or the lifetime gift tax exemption (which is $11.7 million for 2021). However, transfers between spouses during the marriage are generally not subject to gift tax.
Alimony and Tax Deductions
In some cases, the sale of the marital home may coincide with alimony or spousal support payments. Prior to 2019, alimony payments were tax-deductible for the payor and taxable as income for the recipient. However, the Tax Cuts and Jobs Act (TCJA) eliminated the tax deduction for alimony payments for divorces finalized after December 31, 2018. It's important to consider the potential impact of alimony arrangements when selling the marital home.
Depending on the specific circumstances, there may be additional tax implications to address, such as property tax adjustments, home office deductions, or costs associated with home improvements made before the sale. Divorced or married, navigating the tax implications of selling the marital home can be complex. It is highly recommended to consult with a qualified tax professional or divorce attorney who can provide guidance based on your individual situation and the applicable tax laws in your jurisdiction. Here at the Law Office of Bryan Fagan, we understand these complexities and are more than qualified to help you understand the process better.
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