Divorce and Your Home: Guide to Avoiding a Tax Bomb

7 6 minutes read

Divorce can turn your world upside down — emotionally and financially. And when it comes to real estate, the decisions you make during this time can have a lasting impact on your financial future.

Whether it’s the family home or a rental property, real estate is often one of the largest and most emotionally charged assets in a marriage.

As a CERTIFIED FINANCIAL PLANNER® professional and Certified Divorce Financial Analyst®, I’ve walked this road with many clients. I’ve seen the heartbreak, the hidden tax traps and, most importantly, the powerful outcomes when the right guidance is in place.

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Why real estate matters so much in divorce

Your home isn’t just a building — it represents security, memories, and it’s often your most valuable asset. The decisions you make about real estate, whether to sell, keep or share ownership, come with serious financial consequences.

From tax rules to title transfers, the details matter. One small misstep can mean tens of thousands of dollars lost down the road.

What the IRS says about property transfers and capital gains taxes

Let’s start with the tax side. IRS Section 1041 allows for property transfers between divorcing spouses without triggering income tax.

Sounds simple, right? Not quite.

If you’re getting divorced and the family home is part of the settlement, it’s important to think ahead — especially about taxes.

One of the biggest tax breaks available to homeowners is the capital gains exclusion: If a married couple sell their primary residence, they can exclude up to $500,000 in capital gains ($250,000 per person) from taxation, as long as both spouses owned and lived in the home for at least two of the last five years before the sale.

But this gets complicated after a divorce. If only one spouse continues to live in the home — or if the home is sold years down the line — one or both parties could lose eligibility for this exclusion.

That’s why the timing and wording in your divorce agreement matter. If one spouse will remain in the home, the agreement should:

Clearly state that they have the right to stay there
Ensure that the other (non-resident) spouse’s period of use is counted toward the IRS’ two-out-of-five-year residence requirement

In addition, the non-resident spouse must remain on the title of the property during this period in order to satisfy the IRS’ ownership test. Without both of these conditions — use and ownership — the exclusion may not apply, and a future sale could result in a steep, unexpected tax bill.

One couple’s home strategy

Take Sam and Lisa, for example. They divorced in 2023. As part of their settlement, Lisa will continue living in the house for up to six years, or until their youngest child turns 18 — whichever comes first.

At that point, she must either buy out Sam’s 50% ownership interest or cooperate with Sam to sell the property.

Sam’s attorney made sure this arrangement was spelled out in the divorce agreement to protect Sam’s future $250,000 capital gains tax exclusion. Just as importantly, Sam must stay on the title of the home during this time to preserve his eligibility.

“It’s crucial that these real estate provisions are clearly defined in the divorce agreement,” says Alla Roytberg, matrimonial attorney, divorce mediator and founder of Roytberg Traum Law and Mediation P.C.

“We always include language specifying how long one spouse may reside in the home and what happens if plans change. Without these details, enforcement and future cooperation can become difficult, especially if the relationship is strained.”

Thinking of a buyout?

If one spouse wants to keep the house, a buyout can offer clean closure. But it’s not as simple as signing on the dotted line.

The spouse staying in the home usually needs to refinance the mortgage in their name alone. If their income or credit isn’t strong enough, this can become a huge stumbling block.

And then there’s the buyout itself. How will it be paid? Cash? Investments in a brokerage account? Retirement assets? These choices come with tax and liquidity implications.

Refinancing fees, title transfers, closing costs and even transfer taxes also need to be factored into the settlement. And if the property is a co-op or located outside the U.S., that often includes even more layers of complexity.

“Some matrimonial attorneys do not realize that transferring ownership of a co-op may require board approval, and they fail to address the details of the board approval process and also the refinance process in the divorce agreement,” Roytberg says. “This presents problems, because the spouse who seeks to ‘buy out’ the other’s interest may not be approved by the board or may not be able to refinance the loan.

“There needs to be a clear plan for the buyout and an alternative plan, in case the buyout cannot succeed,” she explains. “Getting an experienced real estate attorney involved to review a divorce agreement before it is signed is critical to ensure that the parties’ real estate plans proceed smoothly in the future and they do not end up in court because of the ambiguities and loopholes in their real estate divorce plan.”

Should you sell now or later?

Some couples opt to sell the home right away. Others delay the sale, perhaps until the kids finish school or the market improves. Both choices come with pros and cons.

An immediate sale offers a clean break and clear division of proceeds. But you’ll need to agree on the listing agent, sales price, timing and how to handle costs, such as repairs or staging.

A delayed sale? That opens a new set of questions:

Who pays the mortgage, real estate taxes and insurance?
Who lives in the house?
What happens if major repairs are needed?
How are costs and profits divided?
Who claims the mortgage interest and property tax deductions?
What if one party wants to sell and the other doesn’t?
What are the consequences if one party refuses to cooperate?
Is there a timeline or event that triggers the sale?
What if the home’s market value drops — who bears that risk?

Put everything in writing. That’s how you protect both parties and avoid conflict later.

Rental and investment properties: Hidden risks

Income-producing properties add another layer of complexity. These assets aren’t just about their market value; they generate income, come with maintenance costs and trigger tax obligations.

Rental income is taxed as ordinary income, and when the property is sold, you may face both capital gains and depreciation recapture taxed at your highest income tax bracket. That’s a double whammy many don’t see coming.

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Also, be wary of fuzzy accounting. Inflated expenses or underreported income can obscure the property’s true value and how much it can generate. Make sure the numbers are clear, documented and fairly represented. A professional valuation can go a long way to protect you.

Protect yourself with a clear, loophole-free plan

Real estate decisions in divorce must be thorough and airtight. That means defining:

Who pays what
How decisions are made
What happens if plans change
How proceeds or losses are split
How capital gains taxes will be handled
When the home must be sold, and under what conditions

Don’t wait until after the divorce to sort this out. Legal clarity upfront helps prevent costly disputes and tax surprises later.

You don’t have to figure this out alone

Real estate is more than just an address — it’s a cornerstone of your financial stability. Done right, these decisions can set you on a path toward long-term independence and peace of mind.

If you’re facing divorce, and real estate is part of the equation, a financial adviser and experienced real estate attorney can help you navigate the complexities, avoid costly mistakes and make smart, informed decisions that support your next chapter.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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