I lost my house in divorce. Will I have capital gains later?

Avoid tricky tax problems in divorce property settlement!

Here’s the common situation:
Let’s suppose that you are the primary spouse on marital home’s mortgage. You plan to give your spouse all rights to your home, in the divorce. Your spouse will keep the home, but cannot refinance or remove your name off the mortgage. You might even agree in the Property Settlement Agreement that if the house is sold, you won’t receive any money from the sale. Much later after the divorce, your spouse sells the home for a huge gain – and keeps all the money.
Here’s a problem. Because of the sale, the full amount of proceeds is gets reported to IRS as having been received by you. It appears that, as the primary mortgagor, you could be responsible to report and pay tax on this huge capital gain. Unfortunately, that is a big problem because you never received any funds to pay tax on the gain!

Fortunately, you can avoid problems like this.

Get your family lawyer’s advice on “down-the-road” events!

Here are two especially helpful things to remember about that capital gains tax on the “divorce” house:

First:
In a separation of marital assets, you should pay extra close attention to the value of assets negotiated. While some assets may have greater financial value, they may also harbor hidden liabilities. Remember, potential capital gains tax is hidden in greatly appreciated assets. You should keep track of those potential tax liabilities, as well as what assets and known liabilities you exchanged in the dissolution of marriage.

Part of your asset split could be future capital gains tax!

Have both an experienced family lawyer and tax attorney (or CPA) help explain and plan your overall separation-of-assets. You should benefit from the best planning, well in advance of any sale or disposition. This planning advice is key. Long after the divorce and later sale, IRS’s well-trained professionals could review your tax return for capital gains from the home. Potentially, you could avoid very costly errors with good planning!
When filing your tax return and reporting the marital home sale, have your information ready. Try to provide a clear accounting of everything that affected your cost basis in the asset, at the it was time sold or surrendered. You may discover that because of the well-planned Property Settlement Agreement, you’ll possibly have no capital gain, either from the divorce exchange or the sale.

Second:
Don’t overlook the $250,000 tax exclusion on your home. (Yes, you can possibly avoid tax on $250K of gain, courtesy of Section 121 of the U.S. Tax Code!)
Even after a divorce, each spouse can exclude up to $250,000 in gains on the sale. This only applies when selling your main residence, not a second home, not a vacation property, and not an investment property. As of the date of the sale, you must have lived there for at least 2 of the last 5 years before the sale. Consider that timing when negotiating the Property Settlement Agreement!

Finally, if you took this exclusion in the last 2 years, you are not eligible to exclude the gain from this sale.

What have you experienced? Chime in with your thoughts or comments.