Don’t Make this $10,000+ Tax Mistake in Your Divorce
Why are Mark and Sarah so happy? Because they just sold their home in Seattle for a bunch of money! Savvy taxpayers like Mark and Sarah know they can use Section 121 of the Internal Revenue Code to reduce the tax owed on the sale of their home.
Seattle-area home prices have been climbing sharply for years, outpacing the growth of prices nationally. From January 2016 to January 2021, Seattle-area prices rose 68.8%, compared to 49.9% nationally.[1] In just one 12-month span from January 2021 to January 2022, home prices rose nearly 25%.[2] This growth in home prices means that many western Washington homeowners could face a significant tax bill when they decide to sell their houses.
Fortunately, the federal government has special tax rules for taxpayers selling their homes. If you are homeowner, you should understand the federal tax rules that apply when a homeowner sells their principal residence. And if you are a divorcing homeowner, you definitely need to understand these rules.
About Section 121 of the tax code
When a homeowner sells their principal residence for a profit, or gain, Internal Revenue Code Section 121 allows some homeowners to exclude a portion of the gain from capital gains tax. If your home has appreciated significantly since you bought it, and you decide to sell it, Section 121 may allow you to reduce your tax bill.
This is significant because usually when you sell something for more than you paid for it, you owe capital gains tax on the entire gain. For example, if you purchase a share in a company for $50, and then several years later sell that share for $75, you will likely pay tax on the entire $25 gain ($75 - $50).
Section 121 states that a single taxpayer can exclude up to $250,000 of gain on the sale of their principal residence. Married couples can exclude up to $500,000. To qualify for the exclusion, certain criteria must be met:
Either spouse has owned the principal residence for two of the last five years.
Both spouses have used the principal residence for two of the last five years.
The two years do not need to be consecutive.
The gain exclusion has not been used in the last two years.
Let’s look at an example:
Example 1. Mark and Sarah purchase a home in Seattle in 2000. They sell the home in March 2019 and have a $600,000 gain on the sale. Mark and Sarah meet all the Section 121 criteria, allowing them to exclude $500,000 of the gain from capital gains tax. This means they will only pay capital gains tax on $100,000 ($600,000 - $500,000). Assuming a tax rate of 15%, their total tax bill is $15,000 ($100,000 x 15%).
What Section 121 means for divorcing homeowners
This brings us to our main point: If you are divorcing, don’t keep the house without first estimating what your tax bill will be if you sell the house as a single person.
Let’s revisit Mark and Sarah, but this time assume they are divorcing:
Example 2. In early 2019, Mark and Sarah decide to divorce, and Sarah gets the house in the divorce. A few months later, Sarah decides to sell the house. She has a $600,000 gain on the sale. Sarah meets all the Section 121 criteria, allowing her to exclude $250,000 of the gain from capital gains tax. Sarah will owe capital gains tax on $350,000 ($600,000 - $250,000). Assuming a tax rate of 15%, Sarah’s tax bill will be $52,500 ($350,000 x 15%).
The outcome for Sarah is drastically different depending on whether the home is sold when she is married or when she is single. Even though the gain on the sale is the same, the tax bill has more than tripled. And Sarah alone is responsible for paying it.
|
|
Gain on the sale |
Tax bill |
Who is responsible for paying the tax bill? |
|
Example 1 |
$600,000 |
$15,000 |
Mark and Sarah |
|
Example 2 |
$600,000 |
$52,500 |
Sarah |
Advice for divorcing homeowners
If your home has appreciated in value, you may be on the hook for a significant tax bill when you sell it. Don’t keep the house in your divorce without first understanding the future tax consequences of selling it. Selling the home during the divorce could allow married homeowners to minimize the amount of tax owed and share the burden of paying the tax bill. To learn more, check out IRS Publication 523, Selling Your Home.
Contact Serene Divorce Planning for help assessing the financial and tax implications of keeping the house in your divorce.
This information is educational in nature and should not be relied upon for legal or tax advice. Serene Divorce Planning LLC is not an attorney and does not provide legal or tax advice. Individuals seeking legal or tax advice should solicit the counsel of competent legal or tax professionals knowledgeable about the divorce laws in their own geographical areas. Serene Divorce Planning LLC does not sell or consult on securities.
[1] https://www.seattletimes.com/business/real-estate/seattle-home-price-growth-continues-to-shatter-records/
[2] https://www.seattletimes.com/business/home-price-appreciation-accelerates-again-in-u-s-cities/