Whether and how the capital gains tax affects you during your divorce depends on what you are doing with the house. In general, transfers of property between divorcing spouses are nontaxable. But there are circumstances where the capital gains tax—a tax on profits from sales of property where the gains exceed a certain amount—does apply to transfers that are made as part of your divorce.
If you sell your house, you and your spouse can each exclude the first $250,000 of gain from your taxable income. The capital gains exclusion applies only to your "principal residence," which is defined as a home in which you've lived for at least two of the five years prior to the sale. A vacation house doesn't count.
What's "gain"? In the simplest terms, taxable gain is the selling price of your home, minus the selling expenses, minus your adjusted "basis." Basis is the amount you paid for your house or the amount it cost you to build it, with some pluses and minuses for improvements and tax benefits. Of course, being tax related, your basis is not always simple to figure out.
If you and your spouse sell your house at the time you're getting divorced, the capital gains tax applies. But you're entitled to exclude a total of $500,000 of gain from tax if you lived there for two of the five years before the sale. (If either spouse is in the military that five-year period can be extended for up to ten years under some circumstances.) And if you bought the house less than two years ago the exclusion may be reduced.
After a buyout, the selling spouse doesn't need to worry about capital gains tax because the sale was part of the divorce. But if you buy out your spouse, stay in the house, and later sell the house to a third party, capital gains tax will apply to that sale. You may exclude the first $250,000 of gain—as long as you've lived there for two years before selling, or meet one of the IRS exceptions to that rule.
For a spouse who continues to own the house but doesn't live in it, there's a risk that the $250,000 exclusion might not apply when the house is sold. To avoid losing the exclusion, it's important to have written documentation of the agreement that called for one spouse to stay in the house and the other to leave but remain a co-owner. If it's clear that the arrangement was pursuant to a divorce settlement or court order, then the nonresident spouse can still take the exclusion on the basis of the resident
Capital gains can be confusing. If you have questions about your basis, whether your gain is over the exclusion amount, or other aspects of capital gains taxes, try looking for the answer in IRS Publication 523, Selling Your Home, or ask your attorney or tax preparer to help you figure it out.
Excerpted from Nolo's Essential Guide to Divorce, by Emily Doskow.