capital gains, divorce, DTI, etc

[nikadog]

This situation has various moving parts, as you might guess from the title. Here’s the background:

My wife and I own our home as tenants in common (I’m not sure if that factors in, but I mention it just to be thorough). We are planning on selling our current home in June 2025, give or take. We’ve both lived here continuously since 2016.

When we sell the current home, our ideal scenario is to still be married. However, we are planning a divorce in 2025 - finalizing this either (1) a few months after selling, or (2) on Jan 1, 2026. 

We want to finalize divorce after selling so that we qualify for the $500K capital gains exclusion. Additionally, we’d prefer to finalize the divorce until 2026 so that we can file married jointly (MFJ). So our ideal scenario is (1) sell the house, (2) she buys a different home (I’ll be renting), and (3) stay married until 2026.

However, there are some complications — here are more details:

My wife wants to buy her own home right away when we sell, but since she’s buying as an individual, her income without mine as her co-signer won’t be high enough to qualify for a loan, i.e. her debt-to-income (DTI) will be too high. This problem is solved once she has documentation about the alimony she’ll be getting from me; but of course that documentation isn’t “official” (in the eyes of a lender) until the court approves the divorce agreement.

This suggests we’d need to finalize the divorce in early 2025,so she has documented alimony to help her qualify for a loan. But that complicates our preferred filing status of MFJ.

On to my questions, with apologies in advance for this brain-dump of confusions:

• am I right that we must remain married until 2026 to be able to do MFJ for 2025? iow we’d need to file singly for 2025 if are not married on Dec 31, 2025…is that correct?
• does MFJ or file-singly actually matter in terms of the total cap gains exclusion? i.e. if we’re already divorced, I assume we need to file singly and we’d each get $250K. So this seems to have the same bottom line for us, since we’ve agreed to split home sale proceeds and subsequent taxes 50/50 anyway. Am I missing anything?
• is there other tax liability or downsides we should be aware of, wrt filing singly vs MFJ?

Finally, I realize this is not really a tax-related question: can anyone think of a workaround to get her DTI low enough to qualify w/o the alimony? e.g. can cash-on-hand + great credit score make up for this?

So bottom line, the less-ideal scenario is this: (1) we finalize divorce and establish alimony in early 2025 so that she can qualify for a loan for her own home; (2) we sell our current home as two single people living together with deed as tenants in common; (3) each of us files singly for 2025, and we each get $250 capital gains exclusion; and (4) we split home improvement costs done to the home since 2016, to increase the basis for the home we’re selling and minimize cap gains tax liability, even though we are each filing singly.

The #4 bit seems dicey. Will that work? If only one of us can use the home improvement $ to increase basis, the other person will likely end up in a higher bracket than we’d like. Or am I overthinking this?

Many thanks in advance.

[Critter-3]

Your are overthinking this ... divorce when you want as it is all the same on the tax returns in regards to the exclusion.  You will split the total cost basis equally along with the cost of sale.  Just make sure you each get a 1099-S for 1/2 of the sale at closing. 

[Bsch4477]

You are correct in your assumptions and conclusions.  

[Opus 17 · Accepted solution]

You file your 2025 tax return based on your legal marital status as of 12/31/2025, regardless of what it was for the other 364 days of the year.

If you divorce, each spouse is entitled to a $250K exclusion on their (single) tax return, regardless of whether you sell before or after the divorce is finalized.

You don't mention children.  If there are one or more children under the age of 24 living at home, one or both spouses might be able to file as head of household after a divorce (or after a separation of at least 6 months) and HOH is a bit more favorable than single. 

There are a number of downsides to filing as married filing separately.  Assuming the divorce remains as friendly as it seems to be, and you don't have any significant disagreements or concerns, you can continue to file MFJ.  The biggest legal issue is that when you file MFJ, you are taking joint and several responsibility for all the income, deductions and claims on the return—meaning that if there is a deficiency, fraud, or error, the IRS can come after either one of you, or both, or whoever is easiest to target, even after the divorce, and even if the error was by the other spouse.   For that reason alone, you might want to finalize the divorce as soon as you can, or file MFS, even though the tax rates are higher with MFS, and many credits and deductions are limited or disallowed.  (I suspect a divorce attorney would be horrified at the way you plan to remain entangled for 2+ more years.  That's a long time for things to remain friendly.)

Note that under the rules for the home owner capital gain exclusion, if you were to move out now (for example), and get divorced in 2024 (for example), you would still qualify for your full $250K exclusion even if you sell in 2025 or 2026.  As long as one of the exes lives in the house and meets the 2 year rule, the other ex is deemed to meet the rule as well, even if they moved out early due to separation or divorce.  

I'm not clear on why you think you need to file MFJ for 2024 and 2025.  Most of the time, the taxes owed by two unmarried people filing single will be very close to the taxes owed by the same two people filling as a married couple MFJ, and sometimes, the taxes for being married can be higher (the so-called "marriage penalty", although the effects of the marriage penalty have been reduced by some of the recent tax law changes.)

[nikadog]

My thanks to all who replied - these insights have been very helpful.

So just to be sure, I’d like to paraphrase/summarize what I believe is being said. Please correct me where I’m not quite understanding:

Divorce timing and tax filing status

— staying married and using MFJ means we share financial responsibilities for each other

— staying married but using married-filing-singly (MFS) means higher tax rates and fewer credits/deductions

— we can avoid both the MFJ and MFS concerns by simply filing as single persons

— wrt total tax liability, two us each filing as single persons is not significantly different than using MFJ

— if we divorce at any time during 2025, we must file as single persons for that tax year

Our 2025 returns

— the cap gains exclusion ends up the same: we each get a $250K exclusion

— we can split the total cost basis equally along with the cost of sale

— we each get a 1099-S as documentation for sale proceeds (and, I’d imagine, costs involved in the sale)

— on the 1099-S, the gross proceeds and sale costs are split equally

Head of Household filing status

— depending on what our 18-yo son chooses to do (college out of state? live with Mom or Dad? etc), the HOH filing status is on the table

Scenario of choice

Given all of the above, here’s the plan (and pls correct me where I’m misunderstanding anything):

(1) we should finalize the divorce whenever that makes sense, since it doesn’t affect the financial outcomes:

(2) finalizing the divorce sooner rather than later makes the most sense since that gives my (soon-to-be-ex-)spouse enough time to establish things for an acceptable DTI, so as to qualify for the home loan she’ll need in summer 2025:

• alimony will be established and legally notarized, and thus will be recognized by a lender as income
• she’ll have multiple months with a track record of income and expenses

(3) we sell the home as planned in summer 2025, as two single people living together plus our 18-yo son. There will be no custody issues since he will have reached age of consent.

Again, my thanks.

[Opus 17]

Taking this in parts.

— staying married and using MFJ means we share financial responsibilities for each other

Yes, at least for income taxes. 

— staying married but using married-filing-singly (MFS) means higher tax rates and fewer credits/deductions

Yes, in most cases.

— we can avoid both the MFJ and MFS concerns by simply filing as single persons

Yes, but you can only file as single if you are actually divorced.

— wrt total tax liability, two us each filing as single persons is not significantly different than using MFJ

This is usually true, but the only way to get an exact answer for your situation is for you to prepare test returns with your own facts. (**Also note this is more likely true if your incomes are similar.  If your incomes are very different, the higher income spouse may pay more income tax after the divorce, while the lower income taxpayer may pay less.)

— if we divorce at any time during 2025, we must file as single persons for that tax year

Yes (unless you remarry, or qualify to file as head of household).

— the cap gains exclusion ends up the same: we each get a $250K exclusion

Yes.  If you file a joint return you claim a $500K exclusion, if you are divorced and file single returns, or if you file MFS, you can claim $250K each. 

— we can split the total cost basis equally along with the cost of sale

Yes.

— we each get a 1099-S as documentation for sale proceeds (and, I’d imagine, costs involved in the sale)

— on the 1099-S, the gross proceeds and sale costs are split equally

This should be discussed with the closing agent.  A lazy agent might issue a single 1099-S to one spouse, especially if you are married at the time of the sale and plan to divorce later.  Let the closing agent know what you want them to do.  (Sometimes, for sale of a personal home, a 1099-S is not even required.)

[Opus 17]

Part 2.

— depending on what our 18-yo son chooses to do (college out of state? live with Mom or Dad? etc), the HOH filing status is on the table

Yes, but there are a lot of moving parts to consider.  A child living away from home while attending college is generally considered to live "at home" because college is a temporary absence.  In the case of divorce or separation, the child is treated as living with the parent he would have lived with if not away at college.  (This can be determined by facts and circumstances, such as where are his friends, his doctor, his other significant relationships, and all his personal items that he can't take to college, and where does he return for summer vacation.)

If a child definitively moves out of their parent's home and establishes their own separate residence, with no intent to return to the parent's home except for short visits (no longer use the parents home as a residence), then the child does not live with either parent, and can't be claimed any more as a dependent or used to qualify for HOH.  Although even here, what counts is where the child lived more than half the year, so even if the child definitively moves out in September, they still "lived with" their parent for more than half that year and the parent can generally claim them as a dependent.

There is also a financial test.  If the child provides more than half their own support, they are not a dependent or qualifying person for HOH.  Support the child provides themself include money they earn, their own savings that they spend, and student loans in their name.  Support provided by the parents includes any cash payments for tuition, room or board, other cash assistance, the value of maintaining a residence in the parent's home, and any tuition loans taken out by the parents.   It is possible, depending on job and tuition, for a college student to provide more than half their own support and no longer be a dependent of either parent. 

[Opus 17]

Part 3.

Given all of the above, here’s the plan (and pls correct me where I’m misunderstanding anything):

This is hard to comment on because it is more of a legal and personal question than a tax question.  

For income taxes, as long as at least one of you lives in the current house as their main home until it is sold, you both qualify for the exclusion, even if you legally divorce earlier.  (You don't have to share the house until you sell it, although you certainly can if you are agreeable to doing that.) There can be legal benefits to separating your finances (either by filing MFS or by finalizing a divorce) although you may want to discuss with an attorney.  You will likely owe similar income tax after divorce when filing singly, as when married filing jointly, but this would have to be confirmed using your specific income and other facts.  Filing MFS will result in higher income taxes.  

For mortgage qualifications, you may want to discuss with an attorney or mortgage broker.

[nikadog]

Thanks @Opus 17 ! You are taking a lot of time for me, with very thorough answers. 

And, agreed, I need to speak with a lender to answer DTI questions.

Many, many thanks.