How Does Divorce Affect Capital Gains Tax?

Going through a divorce can be an emotionally difficult time as lives are uprooted during separation. 

Divorce also can bring about some serious tax consequences, especially for couples who sell their primary marital residence and file separate tax returns. High-net-worth couples who own commercial real estate properties also face some complicated financial decisions. 

In this article we’ll look at how divorce can affect capital gains taxes when couples divest key marital assets as part of their divorce settlements. 

Divorce and Primary Residences 

Holding on to the family home can provide important stability to children involved with divorce; however, the decision to keep or sell a primary residence can have consequences on divorcees. 

Married couples enjoy a $500,000 capital gains exclusion on the sale of primary residences. That number is cut in half for single filers. If a divorced spouse doesn’t have sufficient liquidity post-divorce to keep paying the mortgage and expenses for the family home, it could prove more beneficial to divest the asset as joint owners.  

Here is a side-by-side comparison that shows the differences between selling as joint owners or as a single taxpayer:  

The capital gains tax rate could be higher or lower depending on filing status and annual income. If the divorced couple sold the primary residence as part of the settlement, they would split a $7,500 tax bill. If the home was sold at a later date, the sole resident may face a much larger capital gains tax burden. 

If divorced couples retain joint ownership in the family home, they each may be able to claim the $250,000 exemption for single taxpayers if one party sells the home. Each owner would have had to own their part of the residence for a minimum of two years during a five-year period ending on date of sale, and each would have had to use the home as their primary residence for two years during that same time. 

There are other ways that capital gains taxes are affected by divorce. If a divorcee remarries and occupies the home with the new spouse for a minimum of two years, the new couple qualifies for the $500,000 capital gains exclusion. Lastly, there can be language written into divorce decrees that allow divorcees who are not occupying the family home to receive credit for their ex-spouse's occupation of the residence. 

How Divorce Affect Divestiture of Commercial Real Estate 

Unwinding jointly owned income-producing real estate can make divesting the family home seem like a Sunday stroll in the park. 

Divorcees who want complete financial separation will likely have to engage a team of financial and taxation professionals to conduct a deep analysis of each rental property’s financials, lease agreements, ownership structure, and loan documents. A 50-50 split may not be feasible, especially if one party wants to continue holding and operating income-producing real estate. 

First and foremost, couples could simply decide to sell their commercial real estate holdings and split the proceeds. However, this move would likely result in significant capital gains tax liability, especially for highly appreciated assets. Secondly, one spouse could buy out the other’s interests and continue operating the property provided they had enough liquidity to complete the buyout. Another option to avoid generating capital gains taxes is to continue operating income-producing properties and split the proceeds, though this option requires an amicable working relationship between divorcees.  

Putting it all Together 

Couples who are divorcing may choose to work together and form an agreement on how to best divide substantial marital assets such as the family home or income-producing real estate. Divorcees could benefit from capital gains tax exclusions on the sale of their primary residences depending on when they were sold and how they file their tax returns. 

Divesting jointly-held commercial or investment real estate as part of a divorce settlement has a host of financial and tax implications. Any straight sale of commercial or investment assets would likely generate a taxable event on any realized profits. Discussing your particular situation with a team of professionals could be a prudent course of action to help minimize your exposure to capital gains tax liabilities.