Capital gains tax on the sale of home after separation in the US

Question

I bought and lived in my old home with my ex-wife from January 2017 until June 2021, when we moved to a new home. The old home was rented out to tenants until March 2024, when my ex and I decided to separate. I moved back to the old home, while she stayed in the new home. Now (October 2024) we are about to start getting divorced.

Due to COVID and location (Austin, TX) the home price almost doubled since we bought the home in 2017. If I understand the rules correctly, capital gains tax applies to the profit on the home value only if the owner has not lived in the home for at least 2 out of the last 5 years from the date of the sale. I intend to be in the home until March 2025.

So my question is: would I need to pay capital gains tax on the sale of this home? One of us lives in the home, but the other doesn't. We have an amicable relationship so we could potentially make the home 'mine' in the divorce and settle the finances after the sale. I am unsure if there is a hard requirement for both of us to live in the home.

Answer 1

So my question is: would I need to pay capital gains tax on the sale of this home?

Yes.

If I understand the rules correctly, capital gains tax applies to the profit on the home value only if the owner has not lived in the home for at least 2 out of the last 5 years from the date of the sale

No, that's not the correct understanding. You're talking about the IRC Sec. 121 exclusion. There are several wrinkles:

• It is limited to $250K of excluded gain (500K for MFJ filers).
• It excludes the period of the disqualified use (the period it was a rental), and the exclusion has to prorate the gain through only the qualified use years. So even if the total gain is below the maximum, you might not be able to exclude all of it because of the rental use.
• It doesn't include the depreciation recapture (IRC Sec. 1250 gain).

We have an amicable relationship so we could potentially make the home 'mine' in the divorce and settle the finances after the sale. I am unsure if there is a hard requirement for both of us to live in the home.

That may not matter. You should discuss this with your divorce attorney. Generally transfers between (ex) spouses incidental to divorce are not taxable. See the IRC Sec. 121(d)(3) and the IRC Sec. 1041. It may be beneficial to split the gains rather then to allocate the whole thing to you, especially if the gains are >$250K.