Tax Implications of Marital Assets and Division of Property

1040$20smallA. Property Settlement Award Not Taxable. A property settlement award or transfer of property between spouses incident to a divorce is not subject to taxation under I.R.C Section 1041.  It may be beneficial for the parties to reach an agreement that does not divide all of the assets, but instead awards one of the parties a lump sum settlement for their equity interest in the marital property.  For example, the parties may have a home worth $300,000.00 that is encumbered by a $100,000.00 mortgage.  Instead of selling the home, incurring realtor fees, and then dividing the remaining proceeds from the sale, an agreement could be reached that awards the home to one spouse.  In exchange, the individual awarded the home agrees to pay the other party $100,000.00 as a property settlement.  Under this scenario, no taxable gain or loss is recognized on the transfer of the $100,000.00 property settlement pursuant to I.R.C section 1041.

B. Gains from Sale of Personal Residence: I.R.C Section 121(b) provides that an individual may exclude from income up to $250,000.00 of gain ($500,000.00 if sold as husband and wife on a joint return) that is realized from the sale of a primary residence provided the Internal Revenue Service’s ownership and use tests are satisfied.  As a general rule the gain will only be exempt from tax if the home was used as primary residence for an aggregate of two years over the past five years.  So unless the home has increased $250,000.00 in value from the date you purchased it (or $500,000.00 if purchased with a spouse), there will be no taxable gain on the sale of personal residence.  It is important to note that if your client moved out of the residence before the divorce was final, but then ended up getting the house in the proceedings anyway, he/she can still claim the house as his/her primary residence.

In a situation where the home has increased in value, the issue will turn to whether or not the taxpayer primarily resided in the home for a total of two years during the five year period preceding the date of sale.  Any temporary periods of absence of less than an entire year would count as periods of use (e.g. vacation, work travel, or seasonal absences).  In the event of a temporary court order or restraining order that was entered while the divorce or legal separation was pending, I.R.C section 121(d)(3)(B) states that “an individual shall be treated as using property as such individual’s principal residence during any period of ownership while such individual’s spouse or former spouse is granted use of the property under a divorce or separation instrument.” A special exception to the two-out-of-five rules exists for active duty military personnel under I.R.C section 121(d)(9).

If any portion of the gain of a primary residence is associated with a separate dwelling unit, the dwelling unit is subject to allocation and taxation.  You will need to discuss the allocation issues with your accountant.  The dwelling unit will not be lumped in with the primary residence.  The IRS Regulations are clear on the allocation requirements for mixed use property.