Information About the Principal Residence Gain Exclusion Break
We’ve been looking at year-end tax planning on the Illumination Wealth Blog. 2021 is coming to an end soon and there are tax law changes on the horizon for 2022 and beyond. It’s time to adjust your tax plan. Take advantage of new tax benefits while preparing for any tax liabilities that could work against your short- and long-term financial plans.
Today, we’d like to focus on the principal residence gain exclusion break. Here’s a look at how to apply the $250,000 principal residence tax break ($500,000 for joint filers) when getting married or divorced. This tax break may also be applied when converting another property into your primary home.
A home sale often occurs in both marriage and divorce situations. This means the principal residence gain exclusion break can come in very handy when an appreciated home is put up for sale.
Home Sale During Marriage
First, let’s focus on a home sale that happens when a couple is getting married. It’s common for each to already own separate residences during their single years. Once they are married, the couple will generally file their taxes jointly. In this scenario, it is possible for each spouse to individually pass the ownership and use tests for their respective residences. Each spouse would be able to take advantage of separate $250,000 exclusion if both properties are sold. If only one is sold as they move into the other, then the exclusion would of course apply to the sold property.
Home Sale Before a Divorce
When divorces happen, a home sale is often involved unless one spouse retains the property as part of the divorce settlement. In this example, a soon-to-be-divorced couple sells their principal residence. Their divorce is not yet final and they are still legally married as of the end of the tax year. This would allow them to shelter up to $500,000 with the principal residence gain exclusion. This can be done in two different ways:
- Joint Tax Return—The couple could file a joint tax form 1040 for the year of the property sale. As long as they meet the exclusion requirements, they can claim the $500,000 exclusion for joint filers.
- Separate Tax Returns—The couple could also file separate tax returns for the year of the sale, using married-filed-separately status. If the home is owned jointly or treated as community property, each spouse would be able to exclude up to $250,000 of his or her share of the gain.*
*To qualify for two separate $250,000 exclusions, each spouse must have owned his or her part of the property for at least two years during the five-year period ending on the sale date. They must also have used the home as his or her principal residence for at least two years during that five-year period.
Home Sale in Year of Divorce or Later
If the couple is divorced as of the end of the tax year when the property is sold, they are considered divorced for that entire year. Therefore, they will not be able to file jointly for the year of sale. This is also true whenever the sale occurs any year after the divorce is finalized. If the property is sold relatively soon after the divorce, each spouse should still be able to claim the individual $250,000 gain exclusions. If it isn’t sold for some time, they will likely fail to meet the eligibility requirements.
Naturally, this can get more complicated if one ex-spouse continues to live in the home and/or the non-resident spouse retains his or her ownership share in the property. The gain exclusion may not help one of the ex-spouses if the home is sold later. However, this undesirable outcome can be avoided with advanced planning. The non-resident ex-spouse should stipulate certain conditions in his or her divorce agreement. You will want to discuss the terms and options with your divorce attorney and financial advisor to get all the details correct in this complex scenario.
Property Converted into Principal Residence
Once upon a time, you could convert a rental property or vacation home into your principal residence, occupy it for at least two years, sell it and take full advantage of the principal residence gain exclusion break. Unfortunately, it’s not that easy any more. Legislation enacted back in 2008 added a provision that complicated this type of scenario. Now, there is a calculation that happens to determine the “non-excludable gain amount.” You can still use the gain exclusion, but you may not be eligible for the full $250,000/$500,000. Again, consult with your tax advisor or financial advisor to understand the current tax laws and fine tune how your tax plan is structured.
For all your financial planning and tax planning needs, contact Illumination Wealth today. Let us know how we can help you make the most of your financial future or navigate complex tax situations like these.