05 Jun My friend is separated. What happens with taxes on their home sale?

Q. My friend is separated from her spouse. He resides in another state and has for about the last four years and he hasn’t been back. He is on the mortgage alone while they are both on the deed. It has been her primary residence since he left, and if the house is sold, she would remain in New Jersey. My question is whether she would have to pay the exit tax? They probably owe about $180,000 on it and the house is probably worth about $400,000.
— Helping

A. There are two issues your friend will have to consider: the so-called exit tax and the capital gain exclusion on the sale of a principal residence.

Let’s start with the exit tax.

The exit tax is not an additional tax, but a prepayment of the tax owed on the sale of real property by non-residents, said Ann Marie Perry, a certified public accountant with Peapack Private Wealth Management in Summit.

She said as a resident, your friend residing in New Jersey would not be subject to the exit tax prepayment. But her husband’s situation, because he’s living out of state, will require a bit more analysis.

Internal Revenue Code (IRC) Section 121 allows taxpayers filing a joint tax return to exclude up to $500,000 of capital gains on the sale of a principal residence, Perry said.

“Generally, they must use and own the property as their principal residence for at least two of the last five years before the sale,” she said. “For a joint tax return, to claim the full $500,000 exclusion limit, either spouse may meet the ownership test, but both must meet the use test unless a divorce or separation agreement grants only one spouse the use of the home.”

If filing separately, each spouse qualifies for a $250,000 capital gain exclusion, she said.

Reduced exclusions are allowed for taxpayers who fail the two-out-of-five-year test because of change in employment, health or other “unforeseen circumstances,” she said.

According to the IRS, “unforeseen circumstances can include legal separation when under a decree of separate maintenance.”

Perry said your friend’s spouse does not meet the last two-out-of-five-year test since he has not lived in the home for the past four years. He has only one year of living in the home in the past five years based on what you said.

IRC section 121(d)(3)(B) allows a taxpayer who moves out of the marital home to count the time a spouse or former spouse lives in the home per a divorce instrument such as a divorce or separation agreement that’s been executed, she said.

“It can’t just be a situation where one spouse moves out,” she said. “With a divorce or separation agreement in place, as long as one spouse or former spouse meets the use test, both can meet the use test.”

So, the answer will depend on whether your friend has a legal separation agreement in place where her spouse, while living out of state and not meeting the last two-of-five-year test, can qualify to use her time living in the home to exclude his portion of the gain, Perry said.

“As a nonresident, the exit tax will be applied to the spouse living outside New Jersey,” she said. “However, if he can qualify under a legal separation agreement, he could recoup the entire 2% exit tax if he doesn’t owe capital gains tax on the sale of the home.”

If he does not have a legal separation in place, he would owe capital gains tax on his portion of the profit less a reduced exclusion, she said.

“Since he did live in the home at least one of the prior five years, he can qualify for a reduced exclusion,” she said. “The key to his tax situation is whether he has a legal separation and can use your friend’s time in the home for his use test.”

It would make sense for your friend — and her husband — to seek the advice of your tax professional who can examine the specifics of their situation.

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This story was originally published on June 5, 2023.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.