How Divorce & Death Affect Home-Sale Taxes

Selling

The profit you make when selling a home is called "gain" and Uncle Sam may be able to get a piece of it. Fortunately, tax law now excludes from taxation home-sale gains up to $500,000 if you're married filing jointly or up to $250,000 for single filers -- you can walk away with those amounts tax free. There is no need to buy a replacement residence as under the old rules.

Problems can arise when, through divorce or death, one person receives their spouse's share of the home and must report capital gains from the sale of that home as a single tax filer. Fortunately, there are tax options that can help avoid paying more than necessary in capital gains taxes.

For Divorcing Couples

If divorcing homeowners have lots of equity in the home (more than $250,000), capital gains taxes can be minimized if they sell the house, take the gain and divide it as they see fit before they become single taxpayers and lose half their exclusion. (Again, as married home sellers, they can exclude up to $500,000 in gains from taxation, assuming they meet ownership and use tests.)
 
If the house goes to one spouse in the divorce settlement, however, the now-single tax filer who sells the house would have to pay taxes on all gains above their lower $250,000 exclusion limit.

Note: Whatever the home's tax basis was before the divorce remains the same at the time of transfer. (More about "basis" in the following shaded box.) IRS Publication 504, Divorced or Separated Individuals, offers more information.

For Widows, Widowers

Upon the death of a spouse, the surviving spouse can only use the $500,000 capital gains exclusion during the tax year in which the spouse died -- the last year the surviving spouse qualifies for "married, filing jointly" status. If the home is sold after that tax year, as a single filer he or she can only use the maximum $250,000 home-sale gain exclusion.
 
Be aware, however, that a surviving spouse with joint ownership of the home receives the deceased spouse's half interest with a new basis -- one-half of the house's fair market value, usually fixed at the date of death. Added to the surviving spouse's half-portion basis (which remains unchanged), the new basis is likely to be higher, making the capital gain lower at sale time than it would have been before the death.

How To Compute The Tax Basis Of Your Home

To compute the capital gain (profit) on the sale of your home, you must first know your home's "basis" -- your costs to acquire the home plus or minus any "adjustments." You may add certain items to your basis and you must subtract certain other items from it. If your gain is over the exclusion limit, make sure you have added in all qualified basis items.
 
Increases To Basis, (Which Reduce Your Capital Gains Tax Liability When You Sell) Include:
Improvements to your home (e.g., putting an addition on your home, replacing the entire roof, paving the driveway, installing air conditioning, etc., but not home-maintenance expenses)
Assessments for local improvements
Amounts spent to restore damaged property

Items That Decrease Your Basis (And Increase Your Capital Gain) Include:
Insurance reimbursement for casualty losses
Deductible casualty loss not covered by insurance
Payment received for granting an easement or right-of-way
Depreciation deduction for use of your home for business or as a rental property
Value of energy conservation subsidy
Points paid by the seller
Gains deferred on sale of a home before May 7, 1997
 

For detailed information on these basis issues, consult a tax professional or refer to IRS Publication 523, "Selling Your Home," Chapter 2. CLICK HERE.