Tuesday, June 18, 2013

IRS overlooks a divorce- when does that happen?

June 18, 2013, 11:26 a.m. EDT

When the IRS overlooks a couple’s divorce


Divorcing individuals can get up to a $250,000 tax break if they plan ahead


 

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    By Bill Bischoff
    Home sales often occur during or shortly after divorces. With real estate values on the upswing in many areas (finally), the federal income tax exclusion for principal residence sale gains can come in handy. However, divorcing individuals must plan ahead to take advantage. Here’s what to do.
    Gain Exclusion Basics
    An individual can sell a principal residence and exclude (pay no federal income tax on) gain of up to $250,000. A married joint-filing couple can exclude up to $500,000. To qualify, the following tests must be passed.
    Ownership Test: The seller generally must have owned the property for at least two years during the five-year period ending on the sale date.
    Use Test: The seller generally must have used the property as a principal residence for at least two years during the same five-year period.
    Joint-Filer Test: To claim the larger $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.
    Home Sale Occurs Before Divorce
    Say a soon-to-be-divorced couple sells their principal residence. If they are still legally married at the end of the year of sale (because the divorce is not yet final), they can shelter up to $500,000 of home sale profit in two different ways.

    Reuters
    First, the couple can file jointly for the year of sale and claim the $500,000 joint-return exclusion.
    Alternatively, the couple can file separate returns using married filing separate status. Assuming the home is owned jointly or as community property, each spouse can then exclude up to $250,000 of his or her share of the gain. To qualify for separate $250,000 exclusions, each spouse must have (1) owned his or her share of the property for at least two years during the five-year period ending on the sale date and (2) used the home as a principal residence for at least two years during that period.
    Home Sale Occurs in Year of Divorce or Shortly Thereafter
    When a couple is divorced at the end of the year in which their principal residence is sold, they are considered divorced for that entire year. Therefore, they will be unable to file jointly. Here’s the gain exclusion drill in these situations.
    • Say ex-spouse A winds up owing some percentage of the home. Ex-spouse B owns the rest. When the home is eventually sold, both A and B can exclude $250,000 of their respective shares of the gain, provided each person (1) owned his or her part of the home for at least two years during the five-year period ending on the sale date, and (2) used the home as a principal residence for at least two years during that five-year period.
    • Alternatively, say ex-spouse A winds up with sole ownership after the divorce. A’s maximum gain exclusion is $250,000, because A is now single. However, if A remarries and lives in the home with the new spouse for at least two years before selling, A can qualify for the $500,000 joint-filer exclusion.
    “Non-Resident Ex” Has Continued Ownership Long After Divorce
    In many cases, ex-spouses will continue to co-own their former marital abode for a lengthy period after the divorce even though only one ex lives there. Or one ex-spouse may have sole ownership of the home after the divorce while the other ex continues to live there. In these scenarios, it gets tricky for the non-resident ex (the person who still owns part or all of the home but no longer lives there) to qualify for the valuable gain exclusion privilege when the home is eventually sold.

    The twin houses of an odd couple

    Two guys, both recently divorced, decided they wanted to live in the same house, but with separate entrances and totally separate living spaces.
    That’s because after three years of being out of the house, the non-resident ex will fail the two-out-of-five-years use test. So if the home is sold later for a gain, the non-resident ex’s share will be fully taxable. Fortunately, this problem can be finessed with advance planning. Here’s how.
    The person who will be the non-resident ex should insist that the divorce papers stipulate that, as a condition of the divorce agreement, the other ex-spouse can continue to occupy the home for as long as he or she wants, or until the kids reach a certain age, or for a specified number of years, or whatever the divorcing couple agrees on. Once the magic date is reached, the home can either be put up for sale with the proceeds split according to the divorce agreement, or one ex can buy out the other’s share for current market value at that time.
    This language in the divorce papers allows the non-resident ex to receive “credit” for the other ex’s continued use of the property as a principal residence. So when the home is finally sold, the non-resident ex will still pass the two-out-of-five-years use test and thereby qualify for the $250,000 gain exclusion privilege. (Sources: Treasury Regulation 1.121-4(b)(2) and IRS Information Letter IR 2005-0055.)
    Example: Ben and Jen are divorced in September of 2013. Each party retains 50% ownership of the former marital abode. As a condition of the divorce agreement, the decree stipulates that Jen can continue to reside in the home for up to six years (when the youngest child reaches age 18). Then she must either buy out Ben’s 50% interest (based on market value at that time) or cooperate in selling the home. Assume the property is sold six years later. With respect to his 50% ownership interest, Ben passes the use test—even though he has not lived in the home for six years—because he made sure the divorce decree included the magic words (the provision permitting Jen to continue to reside in the home as a condition of the divorce settlement). He therefore passes the use test when the home is sold and qualifies for the $250,000 gain exclusion, which he can use to shelter his share of the home sale profit.
    Jen also qualifies for a separate $250,000 exclusion that she can use to shelter her share of the home sale gain. However, if Jen remarries and she and her new spouse live in the home for at least two years before the sale date, they can qualify for the $500,000 joint-filer exclusion.

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