Selling the Marital Residence: What Are the Tax Implications?

Ownership and Use Test

The principal residence that is sold or exchanged must have been owned and used by the taxpayer for 2 or more years during the 5-year period ending on the date of sale or exchange. IRC '121 (a). Under the Code, the ownership and use test is expressed in terms of the residence being owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating 2 years or more. The ownership and use requirement may be satisfied by establishing ownership and use for 24 full months or for 730 days (365 x 2). Moreover, the requirement may be satisfied during non-concurrent periods if both the ownership and use tests are met during the 5-year period ending on the date of the sale or exchange.' Treasure. ' 1.121-1 ')(1). In establishing whether a taxpayer has satisfied the 2-year use requirement, occupancy of the residence is required. However, short temporary absences, such as for vacation or other seasonal absence (although accompanied with rental of the residence), are counted as periods of use.

A taxpayer who fails to meet the 2 of the past 5-years' ownership and use test by reason of a change of place of employment, health or other unforeseen circumstances is able to exclude the fraction of the $250,000 ($500,000 if married filing a joint return) equal to the fraction of 2 years that these requirements are met. A 'divorce or legal separation under a decree of divorce or separate maintenance' has been determined by the IRS as an unforeseen circumstance.

Title Controls Liability for Tax

The party in whose name the title is held is liable for the capital gain tax, even if the marital settlement agreement or the final judgment awards each party one-half of the sale proceeds. In Suhr v. Commissioner, T.C. Memo 2001-28, title to the principal residence was held by the wife. Nevertheless, the Ohio divorce decree provided that the house 'shall remain in the names of the husband and the wife but granted the wife exclusive possession of the home.' The divorce decree required the husband and the wife to sell the home no later than 8 years after the divorce. Until then, the divorce decree required the husband to pay the mortgage, taxes and insurance on the house. Each party was to receive one-half of the net equity from the sale of the house. The divorce decree did not require the wife to transfer her title to the husband and she never did. When the house was sold, each party received one-half of the proceeds.

The IRS contended in Suhr that the husband was subject to capital gain tax on one-half of the proceeds from the sale of the house because the house was marital property. The tax court disagreed, stating that '[p]roperty need not be jointly owned to be marital property under Ohio law,' and noting that in determining ownership, state law applies. The tax court concluded: 'The fact that the court awarded petitioner one-half of the proceeds of the sale of the home does not mean that it awarded [the husband] an ownership interest in the property. Tax liability is triggered by a taxpayer's ownership interest in property, not by his or her marital interest in the proceeds from the sale of the property.'

Consequently, if the parties are to share the proceeds from the sale of the principal residence equally, and it is the intent of the parties that each is to pay any capital gain taxes out of his or her share, counsel must arrange for title to be in both names. (Title is usually in both names, but not always.)

Principal Residence

Whether property is considered a taxpayer's principal residence depends upon all the facts and circumstances. Treas.Reg. ' 1.121-1(b)(1). If a taxpayer who owns two residences alternates between the two properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer's principal residence. In addition to the taxpayer's use of the property, to quote the Treasury Regulation, relevant factors in determining a principal residence include, but are not limited to:

• The taxpayer's place of employment;
• The principal place of abode of the taxpayer's family members;
• The address listed on the taxpayer's federal and state tax returns, driver's license, automobile registration, and voter registration card;
• The taxpayer's mailing address for bills and correspondence;
• The location of the taxpayer's banks; and
• The location of religious organizations and recreational clubs with which the taxpayer is affiliated. Treas. Reg. ' 1.121-1(b)(2).

These factors can also be excellent guides where residency is challenged when considering subject matter jurisdiction. See also Tiso CA: Long-arm Jurisdiction in Support and Divorce Actions ' The Unwary Beware, Fla. B.J., Dec. 2002, at 91-95.

Joint Filers, Exclusion Up to $500,000

If a joint return is filed, the capital gain exclusion is up to $500,000 if 1) either spouse satisfies the ownership test, 2) both spouses satisfy the use test, and 3) neither spouse is ineligible for the exclusion because of a sale or exchange within the 2-year period. If one spouse is ineligible to use the exclusion because it was used within the 2-year period, it will not preclude the other spouse from claiming the exclusion; however, the entitled spouse will be limited to a $250,000 exclusion. This is exemplified by the following illustration:

Jane sold her principal residence last December at a $100,000 gain. She was single at the time, qualified for and claimed the home sale exclusion. She married James in May and moved into the home that had been his principal residence for the 20 years of his bachelorhood. If James sells the home in July, up to $250,000 of his profit is tax-free. (This illustration is from Highlights of the Taxpayer Relief Act of 1997, (page 4, column 2), with permission of the publisher, Research Institute of America Group.)

In the case of joint filers not sharing a principal residence, an exclusion of $250,000 is available on a qualifying sale or exchange of the principal residence of one of the spouses. Once both spouses satisfy the eligibility rules and 2 years have passed since the last exclusion was allowed to either of them, the taxpayers may exclude $500,000 of gain on their joint return.

Exclusion Every 2 Years

The exclusion can be claimed every 2 years for the sale of a principal residence, but only once during each 2-year period. IRC ' 121 (b)(2)(A). A taxpayer may not ex- clude from gross income gain from the sale or exchange of a principal residence if, during the 2-year period ending on the date of the sale or exchange, the taxpayer sold or exchanged other property for which gain was excluded under IRC' 121. The example set forth by the IRS in Treas.Reg. 1.121-2 (b)(2) is:

Taxpayer 'A' owns a townhouse that he uses as his principal residence for 2 full years, 1998 and 1999. 'A' buys a house in 2000 that he owns and uses as his principal residence. 'A' sells the townhouse in 2002, and excludes gain realized on its sale under section 121. 'A' sells the house in 2003. Although 'A' meets the 2-year ownership and use requirements of section 121, he is not eligible to exclude gain from the sale of the house because he excluded gain within the last 2 years under section 121 from the sale of the townhouse.

Exercise of $125,000 Exclusion under Previous Act

The previous use of the $125,000 exclusion pursuant to the pre-Act version of I.R.C. ' 121 will not preclude the utilization of the now available $250,000 exclusion ($500,000 for married, filing jointly), if all other requirements are met.

Tacking On Ownership of Spouse in I.R.C. ' 1041 Transaction

A spouse or former spouse who has a principal residence distributed to him or her (an I.R.C. ' 1041 transaction) can tack on the transferor's ownership to his or her own ownership. IRC '121 (d)(3)(A).

To illustrate: a departing spouse holds 100% title to the principal residence and has occupied it with the other spouse for 2 or more years. When the departing spouse transfers title to the other spouse or former spouse if incident to a divorce, the departing spouse's ownership will be tacked on to the other spouse or former spouse, enabling that other spouse or former spouse to use the $250,000 exclusion for a sale within 2 years of the transfer. Accordingly, although the new title holder did not own the house for the entire 2 of the past 5 years, the ownership by the departing spouse will suffice. ('If incident to a divorce' means within 1 year after the marriage ceases or within 6 years after the marriage ceases if pursuant to a divorce or separation instrument, thus an I.R.C. ' 1041 transaction. If otherwise, the transfer is presumed not to be related to the cessation of the marriage, which presumption can be rebutted. Temp. Treas. Reg. 1.1041-1T Q&A 6 and 7.)

Use Test Satisfied By Use of Spouse

If one spouse is excluded from the principal residence by virtue of a 'divorce or separation instrument,' the Code will now give relief to the 'out' spouse or former spouse notwithstanding that the principal residence is not sold until 3 years after the 'out' spouse's departure. A 'divorce or separation instrument' is defined in I.R.C. ' 71(b)(2) as (A) a decree or separate maintenance or a written instrument incident to such a decree, (B) a written separation agreement, or (C) a decree (not described in subparagraph (A)) requiring a spouse to make payments for the support or maintenance of the other spouse.' The Code provides that an individual is treated as using the property as that individual's principal residence during any period that the remaining spouse is granted use of the principal residence under a divorce or separation instrument provided that the spouse or former spouse uses the property as his or her principal residence. IRC ' 121 (d)(2)(B); Treas.Reg. 1.121-4(b)(2)

For example, in Young v. Commissioner, 49 T.C.M. (CCH) 1002 (1985), Robert Young was not permitted to avail himself to I.R.C. ' 1034 (rollover of gain from the sale of a principal residence) where his wife and daughter were given exclusive rights to reside in the residence by the divorce decree until the daughter finished her education 3 years hence. (I.R.C. '1034 has been superseded by the amended I.R.C. ' 121; nevertheless, the illustration is instructive.) The Tax Court made the ruling notwithstanding the fact that the divorce decree required Mr. Young to continue to pay the mortgage, real estate, water, taxes and homeowner's insurance on the residence. Now, under the Code, Mr. Young would have the right to exclude up to a $250,000 for any gain resulting from a sale of his interest in the residence any time within 3 years of when his wife and daughter vacated the residence because the ex-wife's use of the residence would be treated as his use.

Similarly, in Perry v. Commissioner, 91 F.3d 82 (9th Cir. 1996), Curtis Perry moved from his residence and commenced living at a woman friend's house. He was divorced a year and a half later. The settlement agreement provided for exclusive possession of the jointly titled house for the wife, to be sold as soon as possible after their daughter reached her majority. Accordingly, Mr. Perry could not take advantage of the non-recognition of gain rule of I.R.C. ' 1034. Now he would have up to a $250,000 exclusion on any gain because the wife's occupancy was pursuant to 'a divorce or separation instrument' and, notwithstanding that he moved, the house still be construed as his principal residence.

Commenting on the new I.R.C. ' 121, Joseph N. DuCanto said:

'This new provision is a proverbial barn-burner for many couples going through a divorce where a highly appreciated home is among the array of assets. Not only does the Act eliminate many of the convoluted rules formerly found which limited use of the former exclusion of $125,000 in gain from taxation, but in one sweep also eliminates the mandatory rollover of gain from one home to another. Do not, however, discard all the historical data related to unrealized gains from prior homes which have been rolled over to the current home, since it appears likely that the adjusted tax basis of the current home will need to be established upon sale of a 'high ticket' home!'

The remark in included in seminar materials prepared and presented by Joseph N. DuCanto at the 1997 annual meeting of the Family Law Section of the Oklahoma Bar Association held in Tulsa in November 1997. DuCanto, of the law firm of Schiller, DuCanto & Fleck, Chicago, is a nationally recognized expert and leader in the field of divorce taxation.

Melvyn B. Frumkes is a nationally known expert on divorce taxation, who has written and lectured extensively on the subject. He practices in Miami and is a member of this newsletter's Editorial Board. Phone: 305-371-5600.

The marital residence is frequently the most valuable asset found in most divorce cases. Issues of valuation, possession and sale will all involve tax implications. The residence may include a houseboat, a house trailer or the house or apartment that the taxpayer is entitled to occupy as a tenant-stockholder in a cooperative housing corporation. It does not include personal property that is not a fixture. Treas.Reg. '1.121-1(b). Any gain represented by the difference between the present market value or sales price and the adjusted basis will have tax consequences. Such gain, unless excluded, will subject the taxpayer to a capital gains tax ' currently 15%. Thus, being familiar with the new rules on the exclusion of gain from sale of a principal residence is essential.

Exclusion of $250,000 of Gain

Under the Taxpayer Relief Act of 1997, incorporated into amended Internal Revenue Code (IRC or Code) ' 121, each taxpayer, regardless of age, can exclude up to $250,000 in gain on the sale or exchange of his or her interest in the principal residence where the ownership and use test is met, unless an election otherwise is made. IRC' 121 (F).

Ownership and Use Test

The principal residence that is sold or exchanged must have been owned and used by the taxpayer for 2 or more years during the 5-year period ending on the date of sale or exchange. IRC '121 (a). Under the Code, the ownership and use test is expressed in terms of the residence being owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating 2 years or more. The ownership and use requirement may be satisfied by establishing ownership and use for 24 full months or for 730 days (365 x 2). Moreover, the requirement may be satisfied during non-concurrent periods if both the ownership and use tests are met during the 5-year period ending on the date of the sale or exchange.' Treasure. ' 1.121-1 ')(1). In establishing whether a taxpayer has satisfied the 2-year use requirement, occupancy of the residence is required. However, short temporary absences, such as for vacation or other seasonal absence (although accompanied with rental of the residence), are counted as periods of use.

A taxpayer who fails to meet the 2 of the past 5-years' ownership and use test by reason of a change of place of employment, health or other unforeseen circumstances is able to exclude the fraction of the $250,000 ($500,000 if married filing a joint return) equal to the fraction of 2 years that these requirements are met. A 'divorce or legal separation under a decree of divorce or separate maintenance' has been determined by the IRS as an unforeseen circumstance.

Title Controls Liability for Tax

The party in whose name the title is held is liable for the capital gain tax, even if the marital settlement agreement or the final judgment awards each party one-half of the sale proceeds. In Suhr v. Commissioner, T.C. Memo 2001-28, title to the principal residence was held by the wife. Nevertheless, the Ohio divorce decree provided that the house 'shall remain in the names of the husband and the wife but granted the wife exclusive possession of the home.' The divorce decree required the husband and the wife to sell the home no later than 8 years after the divorce. Until then, the divorce decree required the husband to pay the mortgage, taxes and insurance on the house. Each party was to receive one-half of the net equity from the sale of the house. The divorce decree did not require the wife to transfer her title to the husband and she never did. When the house was sold, each party received one-half of the proceeds.

The IRS contended in Suhr that the husband was subject to capital gain tax on one-half of the proceeds from the sale of the house because the house was marital property. The tax court disagreed, stating that '[p]roperty need not be jointly owned to be marital property under Ohio law,' and noting that in determining ownership, state law applies. The tax court concluded: 'The fact that the court awarded petitioner one-half of the proceeds of the sale of the home does not mean that it awarded [the husband] an ownership interest in the property. Tax liability is triggered by a taxpayer's ownership interest in property, not by his or her marital interest in the proceeds from the sale of the property.'

Consequently, if the parties are to share the proceeds from the sale of the principal residence equally, and it is the intent of the parties that each is to pay any capital gain taxes out of his or her share, counsel must arrange for title to be in both names. (Title is usually in both names, but not always.)

Principal Residence

Whether property is considered a taxpayer's principal residence depends upon all the facts and circumstances. Treas.Reg. ' 1.121-1(b)(1). If a taxpayer who owns two residences alternates between the two properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer's principal residence. In addition to the taxpayer's use of the property, to quote the Treasury Regulation, relevant factors in determining a principal residence include, but are not limited to:

• The taxpayer's place of employment;
• The principal place of abode of the taxpayer's family members;
• The address listed on the taxpayer's federal and state tax returns, driver's license, automobile registration, and voter registration card;
• The taxpayer's mailing address for bills and correspondence;
• The location of the taxpayer's banks; and
• The location of religious organizations and recreational clubs with which the taxpayer is affiliated. Treas. Reg. ' 1.121-1(b)(2).

These factors can also be excellent guides where residency is challenged when considering subject matter jurisdiction. See also Tiso CA: Long-arm Jurisdiction in Support and Divorce Actions ' The Unwary Beware, Fla. B.J., Dec. 2002, at 91-95.

Joint Filers, Exclusion Up to $500,000

If a joint return is filed, the capital gain exclusion is up to $500,000 if 1) either spouse satisfies the ownership test, 2) both spouses satisfy the use test, and 3) neither spouse is ineligible for the exclusion because of a sale or exchange within the 2-year period. If one spouse is ineligible to use the exclusion because it was used within the 2-year period, it will not preclude the other spouse from claiming the exclusion; however, the entitled spouse will be limited to a $250,000 exclusion. This is exemplified by the following illustration:

Jane sold her principal residence last December at a $100,000 gain. She was single at the time, qualified for and claimed the home sale exclusion. She married James in May and moved into the home that had been his principal residence for the 20 years of his bachelorhood. If James sells the home in July, up to $250,000 of his profit is tax-free. (This illustration is from Highlights of the Taxpayer Relief Act of 1997, (page 4, column 2), with permission of the publisher, Research Institute of America Group.)

In the case of joint filers not sharing a principal residence, an exclusion of $250,000 is available on a qualifying sale or exchange of the principal residence of one of the spouses. Once both spouses satisfy the eligibility rules and 2 years have passed since the last exclusion was allowed to either of them, the taxpayers may exclude $500,000 of gain on their joint return.

Exclusion Every 2 Years

The exclusion can be claimed every 2 years for the sale of a principal residence, but only once during each 2-year period. IRC ' 121 (b)(2)(A). A taxpayer may not ex- clude from gross income gain from the sale or exchange of a principal residence if, during the 2-year period ending on the date of the sale or exchange, the taxpayer sold or exchanged other property for which gain was excluded under IRC' 121. The example set forth by the IRS in Treas.Reg. 1.121-2 (b)(2) is:

Taxpayer 'A' owns a townhouse that he uses as his principal residence for 2 full years, 1998 and 1999. 'A' buys a house in 2000 that he owns and uses as his principal residence. 'A' sells the townhouse in 2002, and excludes gain realized on its sale under section 121. 'A' sells the house in 2003. Although 'A' meets the 2-year ownership and use requirements of section 121, he is not eligible to exclude gain from the sale of the house because he excluded gain within the last 2 years under section 121 from the sale of the townhouse.

Exercise of $125,000 Exclusion under Previous Act

The previous use of the $125,000 exclusion pursuant to the pre-Act version of I.R.C. ' 121 will not preclude the utilization of the now available $250,000 exclusion ($500,000 for married, filing jointly), if all other requirements are met.

Tacking On Ownership of Spouse in I.R.C. ' 1041 Transaction

A spouse or former spouse who has a principal residence distributed to him or her (an I.R.C. ' 1041 transaction) can tack on the transferor's ownership to his or her own ownership. IRC '121 (d)(3)(A).

To illustrate: a departing spouse holds 100% title to the principal residence and has occupied it with the other spouse for 2 or more years. When the departing spouse transfers title to the other spouse or former spouse if incident to a divorce, the departing spouse's ownership will be tacked on to the other spouse or former spouse, enabling that other spouse or former spouse to use the $250,000 exclusion for a sale within 2 years of the transfer. Accordingly, although the new title holder did not own the house for the entire 2 of the past 5 years, the ownership by the departing spouse will suffice. ('If incident to a divorce' means within 1 year after the marriage ceases or within 6 years after the marriage ceases if pursuant to a divorce or separation instrument, thus an I.R.C. ' 1041 transaction. If otherwise, the transfer is presumed not to be related to the cessation of the marriage, which presumption can be rebutted. Temp. Treas. Reg. 1.1041-1T Q&A 6 and 7.)

Use Test Satisfied By Use of Spouse

If one spouse is excluded from the principal residence by virtue of a 'divorce or separation instrument,' the Code will now give relief to the 'out' spouse or former spouse notwithstanding that the principal residence is not sold until 3 years after the 'out' spouse's departure. A 'divorce or separation instrument' is defined in I.R.C. ' 71(b)(2) as (A) a decree or separate maintenance or a written instrument incident to such a decree, (B) a written separation agreement, or (C) a decree (not described in subparagraph (A)) requiring a spouse to make payments for the support or maintenance of the other spouse.' The Code provides that an individual is treated as using the property as that individual's principal residence during any period that the remaining spouse is granted use of the principal residence under a divorce or separation instrument provided that the spouse or former spouse uses the property as his or her principal residence. IRC ' 121 (d)(2)(B); Treas.Reg. 1.121-4(b)(2)

For example, in Young v. Commissioner, 49 T.C.M. (CCH) 1002 (1985), Robert Young was not permitted to avail himself to I.R.C. ' 1034 (rollover of gain from the sale of a principal residence) where his wife and daughter were given exclusive rights to reside in the residence by the divorce decree until the daughter finished her education 3 years hence. (I.R.C. '1034 has been superseded by the amended I.R.C. ' 121; nevertheless, the illustration is instructive.) The Tax Court made the ruling notwithstanding the fact that the divorce decree required Mr. Young to continue to pay the mortgage, real estate, water, taxes and homeowner's insurance on the residence. Now, under the Code, Mr. Young would have the right to exclude up to a $250,000 for any gain resulting from a sale of his interest in the residence any time within 3 years of when his wife and daughter vacated the residence because the ex-wife's use of the residence would be treated as his use.

Similarly, in Perry v. Commissioner , 91 F.3d 82 (9th Cir. 1996), Curtis Perry moved from his residence and commenced living at a woman friend's house. He was divorced a year and a half later. The settlement agreement provided for exclusive possession of the jointly titled house for the wife, to be sold as soon as possible after their daughter reached her majority. Accordingly, Mr. Perry could not take advantage of the non-recognition of gain rule of I.R.C. ' 1034. Now he would have up to a $250,000 exclusion on any gain because the wife's occupancy was pursuant to 'a divorce or separation instrument' and, notwithstanding that he moved, the house still be construed as his principal residence.

Commenting on the new I.R.C. ' 121, Joseph N. DuCanto said:

'This new provision is a proverbial barn-burner for many couples going through a divorce where a highly appreciated home is among the array of assets. Not only does the Act eliminate many of the convoluted rules formerly found which limited use of the former exclusion of $125,000 in gain from taxation, but in one sweep also eliminates the mandatory rollover of gain from one home to another. Do not, however, discard all the historical data related to unrealized gains from prior homes which have been rolled over to the current home, since it appears likely that the adjusted tax basis of the current home will need to be established upon sale of a 'high ticket' home!'

The remark in included in seminar materials prepared and presented by Joseph N. DuCanto at the 1997 annual meeting of the Family Law Section of the Oklahoma Bar Association held in Tulsa in November 1997. DuCanto, of the law firm of Schiller, DuCanto & Fleck, Chicago, is a nationally recognized expert and leader in the field of divorce taxation.

Melvyn B. Frumkes is a nationally known expert on divorce taxation, who has written and lectured extensively on the subject. He practices in Miami and is a member of this newsletter's Editorial Board. Phone: 305-371-5600.