Gain from the sale of real property squarely meets the definition of gross income per IRC § 61(a)(3). The amount of gain realized is determined under § 1001(a) by deducting the basis in the property (The property’s cost plus amounts spent on improvements) form the total amount realized which is generally the proceeds and fair market value of any other property received. Per § 1001(c) the gain realized is recognized unless an exception applies. IRC § 121 provides for an exclusion from the gain required to be recognized of $250,000 for a qualifying individual (or $500,000 for a qualified married couple). Any gain in excess of the exclusion amounts in § 121 is taxed IRC § 1(h) long term capital gain on assets held in excess of one year, which are taxed at either 15% or 20%, depending upon the amount of the taxpayer’s taxable income and filing status.
Where the taxpayers are divorced, or filing married separate returns while still married, each spouse is required to report his or her allocable share of the capital gain. Where the taxpayers are married and file a married filing joint return, the entire gain will be reported and each spouse will be jointly and severally liable for the total tax shown on the personal tax return.
Divorce Tax Consequences of IRC §121
Section 121 permits qualifying taxpayers to exclude gain of up to $250,000 ($500,000 for qualifying joint filers) realized on a qualified sale of their principal residence once every two years. Gain is excluded where the taxpayer satisfies the following requirements.
the taxpayer (or, his or her spouse where filing a joint return) has owned and used the home as his or her principal residence (need not be contiguous), for two of the five years immediately prior to the sale, and the taxpayer has not utilized § 121 within the two years immediately preceding the current sale.
Limited exceptions to the ownership, use, and frequency of sale rules for circumstances that are basically beyond the taxpayer’s control are available under § 121(c) exist. However, their use will result in the exclusion being reduced. These exceptions include:
If a couple both satisfy the 2-year use requirements, but only one satisfies the ownership requirement, the couple is never the less eligible for the maximum § 121 $500,000 exclusion of gain. If only one spouse meets the 2 – year use requirements, the couple is only eligible to exclude $250,000 even where both own the property.
IRC § 121(d)(3) delineates two special rules when separated and or divorced taxpayers sell a principal residence. The first special rule applies where a selling spouse obtained the home from his or her spouse or former spouse in a qualifying § 1041 transaction in which case the selling spouse’s holding period includes the his or her spouse or former spouse’s holding period. The second special rule applies where a spouse or former spouse is granted use of the home under a § 71(b)(2) divorce decree, separation agreement, or spousal support order and used the property as his or her principal residence, in which case the occupancy period granted by the § 71(b)(2) instrument is imputed to the spouse that does not reside in the residence.
However, the above should be handled with care since the danger of a potential tax trap exists: A spouse’s individual use of the marital home prior to the execution of a § 71(b)(2) divorce decree, separation agreement, or spousal support order will not be imputed to the non-occupant spouse for purposes of the above special rules. Thus, both the timing of the sale of the principal residence and the timing of a spouse’s departure from the marital home (separation date) could become strategic where a full $500,000 § 121 exclusion is needed and desired.
Additionally, under 121(b)(4), where a surviving spouse sells within two years after the date of death of his or her spouse and the use and time requirements of § 121(b)(2)(A) were met immediately before the date of death the surviving spouse can claim a $500,000 exclusion.
Partial § 121 Exclusion are available on “Certain” Sales under 121(c)(2)(B) where the sale is occurring because of qualifying “unforeseen circumstances” that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence that are delineated in Reg. § 1.121-3(e). Generally, to receive a reduced exclusion, taxpayer must be able to make it clear, in consideration of all the relevant facts and circumstances, the primary reasoning behind the decision to sell was an unexpected a change in place of employment, health or other qualifying unforeseen circumstance.
Factors the regulations analyze to determine the taxpayer’s primary reason for the sale include:
The timing of the circumstances allegedly causing the sale and the ultimate sale date;
If the suitability as a principal residence of the property that was sold was materially altered by unforeseen circumstance;
If the taxpayer’s financial ability to maintain the property was materially diminished by the unforeseen circumstance;
Whether the taxpayer has actually used the property that was sold as their principal residence;
Whether the circumstances that gave rise to the sale were reasonably foreseeable at the properties purchase date;
Whether the unforeseen circumstances that the taxpayer claims to have led to the need to sell actually occurred while the taxpayer’s owned and used the property at issue.
Where a taxpayer claims the sale was due to a change in place of employment, the services analyzes if the sale was actually motivated by a change in the location of the qualified individual’s employment. The regulations provide a safe harbor where the qualified home owner’s new location of employment is at least 50 miles further from the residence that was sold than the taxpayer’s former place of employment was.
What if my Home was Also Used for Business Purposes?
The regulations under Reg. § 1.121-1(b) adopt a facts and circumstances test to determine if a dwelling qualifies as a taxpayer’s principal residence.
Where a residence has been used for both business and personal residence purposes. i.e. where a residential home or portion of it, is rented or used as a home office. IRC § 121(d)(6) provides that any gain that is realized, may not be excluded under IRC § 121 to the extent of post May 6, 1997 depreciation that was claimed.