Keeping the House in a Divorce: The Capital Gains Trap

The exclusion halves the year the divorce is final

When a married couple sells the home they live in, up to $500,000 of the gain is free of tax. The figure most people carry in their heads is that one.

The figure that applies after a divorce is $250,000. The larger exclusion belongs to a joint return, and once the divorce is final you are filing as a single person. There is no transitional rule and no allowance for having been married when the gain was earned. The exclusion is decided by your filing status in the year the house is sold.

On a home bought in the late 1990s or early 2000s in most of the country, the gain since purchase can comfortably exceed $250,000. Whatever sits above the exclusion is taxed as capital gain when you sell — at 15 or 20 percent federally, with a further 3.8 percent on higher incomes, and state tax where it applies. That bill did not exist while you were married. It appears the day the decree is signed, and it is not on the settlement spreadsheet unless someone put it there.

The house arrives with his basis, and paying for his half does not change that

Property passing between spouses as part of a divorce is not a taxable event. Nothing is owed at the moment the house becomes yours. That is the good news, and it has a consequence that is less often explained.

Because the transfer is not taxed, the basis is not reset. You take over the original cost basis of the house — the purchase price plus capital improvements — as if you had bought it yourself on the day it was first bought. His half of the gain that had built up over the marriage does not stay with him. It comes to you with the deed.

This holds even when you pay for it. Buying out your former husband’s half for $200,000 does not give you $200,000 of basis in that half. The law treats a buyout between divorcing spouses exactly as it treats a gift between them, and the basis carries over regardless of what changed hands. It is one of the few places in the tax code where paying full value for something buys you nothing on the day you sell it.

Basis also depends on records, and after a divorce the records are often in the other household. The closing statement, the receipts for the new roof and the kitchen — every one of those raises the basis and lowers the gain. Ask for them while the file is still open.

The two tests, and the divorce rules that help

To use the exclusion at all, you must have owned the home and lived in it as your main residence for at least two of the five years before the sale.

Divorce carries two rules that make those tests easier to meet than they look. Time your former husband owned the house counts as time you owned it, once it passes to you in the divorce — so the ownership test is rarely a problem. And if the divorce agreement grants you use of the home, the time you live in it counts as his use too. A spouse who moved out years ago can still meet the use test for his own $250,000 when the house is finally sold, provided he still owns his share.

That second rule is why some settlements defer the sale rather than transferring the house. If the plan is to sell once the youngest child finishes school, keeping both names on the title until then can preserve two exclusions instead of one. It has to be written into the decree, and it comes with its own risks, but the alternative is giving up a quarter of a million dollars of exclusion for the convenience of a clean title.

A house and a retirement account are not the same dollar

The usual trade in a divorce after fifty is the house against the retirement account. She keeps the home; he keeps the 401(k). Two assets appraised at the same figure, treated as an even split.

They are not even, and the mistake runs in both directions. A traditional retirement account has never been taxed. Every dollar withdrawn from it is ordinary income, at ordinary rates, and the required withdrawals start whether the money is needed or not. A $600,000 account might be worth $450,000 after tax, depending on the bracket it is drawn in.

The house is taxed differently. Part of its gain is excluded outright; the rest is capital gain at lower rates; and nothing is owed until it is sold. Against that, it costs money to hold — property tax, insurance, maintenance — and it cannot be drawn down a thousand dollars at a time.

Tiffani Lindstrom, CPA does the comparison after tax, on the actual basis and the actual bracket, because the two assets can be $150,000 apart once that is done. The question is never which asset is larger. It is which one leaves more in the account after the tax that each of them carries has been paid.

Before the decree is signed

Three things are worth settling while there is still someone to negotiate with.

Establish the basis. Get the purchase documents and every improvement receipt into your own file before the household separates its paperwork.

Decide whether the sale should come before the divorce or after it. If the house is going to be sold anyway, selling it in a year you can still file jointly uses the $500,000 exclusion rather than the $250,000 one, and the difference can be a five-figure tax bill.

And if you are keeping the house, get the after-tax number, not the appraisal. It is the only figure that tells you what you are actually being given.