When couples are divorcing and they own a home and also a rental property, often what happens is that one spouse moves into the rental property. Seems like a good plan, right?
In 2008, congress passed the Housing Assistance Tax Act. Under that law, for any period after December 31, 2008 that a property was used for a “non-qualified” use, capital gains will apply.
Let’s use an example. A Jane and Bob buy a rental property on January 1, 2016 for $300,000. On January 1, 2018, Bob moves in and begins to use it for his primary residence. On January 1, 2021, the property is sold for $500,000. Two-fifths of the period the property was owned it was used for “non-qualified” use. Therefore, 2/5th of the $200,000 capital gain, or $80,000, is included in gross income. The remaining $120,000 is excluding from tax under the current $250,000 capital gains home sale exclusion. If there was depreciation taken while the property was being used as a rental, that must be recaptured, reported on IRS Schedule D, and a flat 25% tax on the depreciation deduction must be paid.
It’s important to consult with a CPA if a spouse moves into a rental unit when they separate so that the tax that will be due is included in negotiations. This can be difficult to determine if the spouse has not yet sold the home because the pro-rata portion that the property was used as a rental vs. primary residence is currently unknown.