For high-asset couples, homes and capital gains taxes are two of the most significant sources of disputes during divorce. This is further complicated by the fact that in hot housing markets, homes are one of the most common sources of capital gains. The combination can make it particularly complicated for couples to resolve disagreements about dividing the family home.
However, capital gains taxes are not inevitable. There are several ways divorcing couples can mitigate these taxes on a home sale. Reducing the tax burden can help streamline your divorce and minimize its financial impact. Here is what you need to know about these gains, how they get taxed during divorce, and how you can mitigate the amount you’ll be taxed after your split.
What Are Capital Gains?
Capital gains are the increases in worth you receive from assets after their value rises over time. These gains are usually “realized” or legally and financially acknowledged after an asset is sold. If someone is willing to pay a higher price for an asset than the seller initially spent on it, the property has clearly appreciated, and the seller profited off it.
Many types of assets can lead to capital gains. The term is often applied to stocks, bonds, and other investments. However, it also refers to any other property or possession that can be sold for more than its original purchase price.
This is why these gains are so often found in home sales. Particularly in real estate markets like California, where prices consistently and rapidly rise, houses are usually sold for significantly more than the owners originally paid. The difference between the original purchase price and the sale price is the capital gain the owners have realized.
These gains matter because they are usually taxed. In most cases, if you sell stock or another investment, the government requires you to pay a certain percentage of the amount you gained in the sale in tax. It’s this tax that makes capital gains such a problem in divorces.
Capital Gain Taxes and Divorce
If you’ve owned a home with your spouse for years or decades, it’s likely that the value has significantly increased. That can pose a problem in a divorce because no matter how amicable your split may be, you will likely choose to sell or divide your home. The capital gain on your property can complicate the asset division process unless handled carefully.
For instance, if you and your spouse opt to sell the home and split the proceeds, you may need to factor in the capital gains tax when dividing the funds and other assets. Similarly, if you offer to buy out your spouse’s share of the property, they may be responsible for paying taxes from those funds. That can make them hesitant to accept your offer since they could have to pay tens of thousands of dollars from their share of the proceeds. This is why minimizing taxes on these gains is critical for a smooth divorce.
However, as mentioned early, capital gain taxes on the sale of a home aren’t inevitable. Suppose your primary residence has appreciated significantly since you and your spouse bought it. In that case, you may still be able to reduce or avoid these taxes through a convenient IRS tax exclusion.
The federal government encourages people to live in and improve the homes they buy instead of renting them out to maintain a healthy housing market. One way it does this is by offering a significant tax break on capital gains made on a primary residence. If you and your spouse used the property as your main home, you could exclude up to $500,000 in gains as a married couple or $250,000 as a single person.
That difference is why capital gains can become such a problem during a divorce. If you’re not careful, your split can lead you to owe taxes on $250,000 that you otherwise wouldn’t have been obliged to pay.
Minimizing Capital Gain Taxes on Homes in Your Divorce
So, how can you potentially circumvent high tax bills on your home sale? That’s an excellent question. There are four primary strategies you may use to mitigate your tax bill if your home’s worth has increased by more than $250,000 since you purchased it.
1. Sell Before Your Divorce Is Finalized
The simplest way to make the most of the marital tax exemption is to sell your home the year before your divorce is finalized. Many states have months-long waiting periods before a divorce can be completed, which may mean your split extends from one year into the next. For example, California has a six-month waiting period. If you file for divorce in August 2023, it cannot be finalized before February 2024.
This can be invaluable for minimizing taxes because you will file taxes for 2023 as a married couple even though you were in the process of ending your marriage. If you sell your primary residence before 2024, any gains you make in the sale will be sheltered under the $500,000 married couple exclusion, potentially saving you tens of thousands of dollars. However, if you want to keep the home or if you don’t want to wait until the new year to finalize your split, this isn’t the best solution.
2. Divide Ownership and Sell
If you and your spouse split ownership of the house but continue to live in it together after your divorce, it remains your primary residence. As such, you will both remain eligible for the capital gains tax exclusion. If you jointly decide to sell the home in the future, you will still receive a total of $500,000 in tax exemptions.
The primary problem with this approach is that many couples are eager to live separately after divorce. If either of you moves out, that person will no longer receive the $250,000 tax exclusion on their half of the home’s sale proceeds.
3. Maintain Eligibility for Tax Exemptions Through Your Divorce Decree
Suppose you don’t want to live together after your divorce but want to share ownership of the home. In that case, you can maintain eligibility for the marital capital gains tax exemption through your divorce decree. The IRS permits you to stipulate in your decree that one spouse may continue to live in the home as their primary residence for a set period. After the period expires, the house may be sold, or one spouse may buy out the other’s share at the then-current market value. This allows the non-resident spouse to receive “credit” for the other’s continued residency and grants both people their $250,000 exemption.
4. Maintain the Home Into a New Marriage
If you want to keep the home and don’t want to share ownership after the divorce in any circumstances, your capital gains exemption on any future sale will be reduced to $250,000. However, there is one final way to circumvent this. If you maintain ownership of the home into a subsequent marriage, you and your future spouse will again have the half-million exemption. If you plan on remarrying, this can be an effective strategy that allows you to retain full ownership of the property without the need to sell on or before a specific date. If you have any questions about capital gains taxes and your divorce, do not hesitate to consult an experienced high-net-worth divorce attorney. They will assist you with the complexities of tax law and divorce and ensure you receive a fair and financially beneficial divorce settlement.