Divorcing spouse could lose tax exemption on home-sale profits

The Internal Revenue Service sometimes allows an exception to its two-year “residency requirement” if the sale of a home is part of a divorce agreement.

Q. I am in the process of getting a divorce, but I have agreed to allow my wife to continue living in our longtime home until our twin boys graduate from high school about eight years from now. If we sell after they graduate, how would my half-share of the profit be taxed?

A. You have asked an interesting question that shines a spotlight on a little-known but potentially lucrative loophole in the nation's tax laws.

Most readers of this column know that married couples who file their taxes jointly can keep up to $500,000 of their home's resale profit tax-free, provided they meet the Internal Revenue Service's “personal residency” requirement, which states that the property must have been their primary residence for at least two of the previous five years. Single tax-filers can keep up to $250,000 if they meet the two-out-of-five rule.

If your current spouse continues to live in the house until your kids graduate eight years from now, in 2018, she'll obviously meet the residency requirement and automatically qualify to keep up to $250,000 in her profit away from the IRS. But assuming you move out when the divorce is soon finalized, you wouldn't meet the two-out-of-five rule when the property is sold eight years from now and thus could face some hefty taxes on your share of the proceeds.

Here's where the loophole that could save you a lot of money comes in. By inserting just a paragraph or two in your divorce agreement that says she and the boys can stay in the house for up to eight years or by including just about any other terms that set guidelines for her use and eventual sale of the property the IRS may grant you an exemption to its residency requirement and allow you to keep your own profits tax-free, too, even though you would no longer meet the two-out-of-five rule.

Order a free copy of IRS Publication No. 523, Selling Your Home, by calling the IRS at (800) 829-3676 or by downloading it from www.irs.gov. We're talking about saving possibly tens of thousands of dollars in taxes here, so it's also important to discuss this idea and other options with both your divorce lawyer and an accountant or similar professional.

Q. I'm not sure if this is really a real estate question, but I will ask it anyway because I know you know a lot about construction. So how much wood could a woodchuck chuck if a woodchuck could chuck wood?

A. I'm not sure if you've asked a real estate-related question either. But since wood is used to build houses, I'll stretch my beloved editor's boundaries and answer your, er, “gnawing” query.

Woodchucks are groundhogs. That means that they don't throw, or “chuck,” wood. They don't eat it, either.

Of course, if a woodchuck could chuck wood, the daily results would depend on the size and strength of the glorified gopher. They also would rely on the individual woodchuck's work ethic: Like people, some are willing to labor harder than others.

Such mathematical and work-ethics issues aside, New York state wildlife expert Richard Thomas notes that a woodchuck chucks about 35 cubic feet of dirt when digging a burrow for a new home. That means that an average-size woodchuck could toss about 700 pounds of wood in the same amount of time, which is roughly the amount of lumber needed to frame a mid-size closet.

Q. I am a widow. If I create the type of basic living trust you recently wrote about so that my son can quickly inherit my house when I die instead of spending lots of time and money in probate court, would the trust itself first have to be registered with the courts to be legally valid after I pass away?

A. No. A trust is a private document and thus does not have to be recorded with the courts to be valid.

A few states have laws that technically require the registration of a newly created trust, but several lawyers have told me they have never heard of any penalties that have been imposed on homeowners who ignored such requirements. And even if a penalty were to be levied, it still would have no effect on the validity of a trust that has been properly prepared.

For the booklet “Straight Talk About Living Trusts,” send $4 and a self-addressed, stamped envelope to David Myers/Trust, P.O. Box 2960, Culver City, CA 90231-2960.

© 2010, Cowles Syndicate Inc.