Divorce and $500k house sale - can both ex-spouses still claim the $250k capital gains exclusion separately?

But wait, if only one spouse continues living in the house after separation but before the divorce is final, does that spouse get the full $500k exclusion or just their own $250k?

Only the spouse who continues to live in the home would maintain the "use" test on their own. Once divorced, they would each qualify for their individual $250k exclusion (not the $500k married exclusion). The non-resident ex-spouse could possibly still qualify under a special exception in the tax code. When a divorce instrument grants one spouse the right to live in the home, the spouse who moved out can still count the resident ex-spouse's use of the home as their own use for purposes of the exclusion. However, they must still meet the ownership test independently, and specific paperwork must be in place.

How does taxr.ai work exactly? Did you have to upload personal documents or something? I'm dealing with a similar situation but I'm paranoid about privacy.

Did it help with the 2-out-of-5 year calculation? My CPA seems confused about how that applies in my divorce situation... especially since I moved out 18 months ago but we're still joint owners.

You don't have to upload any sensitive documents if you don't want to. You can just describe your situation and ask specific tax questions. It's basically like having a tax professional analyze your situation without the $300/hour fee. The 2-out-of-5 year rule was exactly what I was confused about too! It walked me through scenarios based on when each person lived in the house and showed how the exclusion would apply in each case. We figured out that having language in our divorce agreement about the continued use of the house would protect my ex's ability to claim the exclusion even though he had moved out.

Wait, how does that even work? The IRS never answers their phones. Is this legit?

Sounds like a scam to me. Nobody gets through to the IRS these days. What's the catch? Do they charge a fortune for this "service"?

It's totally legit. They use some kind of system that keeps dialing and holds your place in line so you don't have to stay on hold yourself. When an agent picks up, you get a call back and connect directly. There's no catch - they don't talk to the IRS for you or ask for any personal information. They just get you past the impossible phone system. I spent literally weeks trying to get through on my own before using this, so it was absolutely worth it for me.

No, they didn't mention anything specific about passive activity loss limitations. They do have pretty high incomes though, so that's a really good point. I'll suggest they ask about this specifically. Do you know if spreading the sales across different tax years would help with this issue? Maybe that's another reason the accountant suggested waiting on the primary residence sale?

Spreading sales across tax years could definitely help, especially if their income will be lower after the divorce (filing single vs jointly). Passive losses are limited when your modified adjusted gross income exceeds $150,000, and unused losses carry forward. If they sell the rentals first and have unused losses that carry forward, those losses could potentially offset some gains from selling the primary residence in the following year. Of course, that has to be balanced against the benefits of the primary residence exclusion. Also, if either of them qualifies as a real estate professional (750+ hours/year in real estate activities), that could change how passive losses are treated. It's complicated stuff - they should definitely discuss these specifics with their accountant.

I tried using the "temporary absence" argument in my divorce and it backfired. The IRS questioned my intent - since I had no plans to move back, they didn't consider it temporary. We ended up having to rely on the specific divorce instrument language instead. Better to have proper documentation in the divorce agreement than trying to argue "temporary absence" after the fact.

This is really helpful! I'm actually going through something similar and hadn't considered how the passive activity loss rules might work differently when filing separately vs jointly after divorce. Quick question - you mentioned that income dropping after divorce could help with using rental property losses. Is that because the $150k AGI threshold for passive loss limitations would apply to each person's separate income rather than their combined income? So if they were making $200k combined but only $100k each separately, they might be able to use losses they couldn't use before? Also, do you know if there's a specific timeframe the divorce decree language needs to be in place before the sale, or can it be added retroactively?

@Eva St. Cyr Exactly right on the passive loss limitations! When married filing jointly with $200k combined income, they re well'above the $150k threshold where passive losses get phased out. But filing separately at $100k each could put them back in the range where they can use up to $25k in passive losses annually. Regarding the divorce decree language - it needs to be in the actual divorce or separation instrument before the sale occurs. You can t add'it retroactively after the fact. The IRS is pretty strict about this - they want to see that the use arrangement was formally documented as part of the divorce proceedings. That said, if you re still'in the middle of divorce proceedings, you might be able to get a temporary separation agreement that includes the necessary language about home use, then incorporate it into the final decree. The key is having it documented before the sale happens. One more thing to watch out for - make sure the decree specifically grants the right to use the home, not just says someone can live there. The IRS wants to see clear language about the legal right to occupy the property.

That's a really interesting point about the 1031 exchange! I hadn't thought about how divorce timing could affect the ability to do exchanges. One question though - if they do a 1031 exchange on the rental properties, wouldn't that just kick the tax liability down the road? And if they're splitting assets in the divorce, how would they handle the deferred gain obligation? Would both spouses be responsible for the future tax liability even if only one of them ends up with the replacement property? It seems like this could create some messy issues in the divorce settlement if they're not careful about how the exchange property and associated tax obligations get allocated.