My wife and I are going to separate and we have 2 properties in California. Are we able to each have one of those homes as a primary residence from a tax perspective?

[cofe]

My wife and I are going to separate and we have two properties in California (one is currently being used as a rental property).  As part of our separation one of us is going to take residence of the rental property.  Are we able to each have one of those homes as a primary residence from a tax perspective?

[Opus 17]

I don't understand what you mean.  You can live anywhere you like.  There are no direct tax implications of dividing property during a divorce, whatever property is transferred is not taxable to one person or deductible by the other spouse.

However, you have a potential problem with capital gains tax and depreciation recapture whenever the spouse who gets the rental tries to sell.  You may want an expert accountant to review the situation with you, so you understand the effects of the capital gains tax and decide if the exchange is fair or if some money needs to change hands as well.  Let me try and explain. 

Generally, when you sell a home that you have used as your main home for at least 2 of the past 5 years, and owned at least 2 years, you can exclude the first $250,000 of capital gains from taxation (or $500,000 when married filing jointly).  So spouse X gets the house you have been living in as your main house.  As long as spouse X keeps living there, then whenever they sell, the first $250,000 of capital gains is tax-free.  (Gain more than that is taxed as long-term capital gains at 15% or 20%).

However, you can't move into a rental for 2 years and claim the full gains exclusion.  The exclusion was intended for people who own the home where they live, and not for landlords to convert their taxable gains into tax-free gains by moving back to the house for a short period of time.  This is called non-qualified use, and it works like this:

Non-qualified use means any period after 2008 where neither you nor your spouse (or your former spouse) used the property as your main home.  Suppose you bought the home in 2000, and lived there until 2005, then turned it into a rental.  After the divorce, spouse W moves back into the home in 2022, and sells the home in 2025.  The period of time from 2000-2008, and the period from 2022-2025, is qualified, but the period from 2009-2021 is non-qualified.  You owned the home for 25 years, with 11 years being qualified.  That means that only 11/25th of the gain is eligible for the exclusion, and 14/25th is not eligible for the exclusion.

Furthermore, you have to pay recapture on any depreciation you took or could have taken while the home was rented, and depreciation recapture is taxed higher than capital gains.  (Recapture is taxed as ordinary income with a cap of 25%, capital gains is taxed at 15% or 20%.)

So let's consider an example.

House #1 was bought as your home in 2000, turned to a rental in 2005, spouse W moved back in 2022, and sells in 2025.  The house was bought for $200,000 and sells for $600,000.  You probably took about $100,000 of depreciation when it was a rental.  So,

1. first, you pay 25% depreciation recapture on the $100,000 of depreciation
2. then you have a $400,000 gain, which is 11/24th qualified.
3. your qualified gain is $183,000 which is tax-free because it is less than $250,000.
4. your non-qualified gain is $216,000 which is taxable as long-term capital gains and taxed at 20%.
5. your total tax is $68,200.

Meanwhile, you bought house #2 as your main residence in 2005 and lived there until 2022, when spouse X takes over, and spouse X sells in 2025.  House #2 also cost $200,000 and sells for $600,000.

1. spouse X can exclude $250,000 of gain from tax
2. the remaining $150,000 gain is taxed at 15% or 20% as long term capital gains.
3. spouse X's total tax is $22,000 to $30,000.

So even though the houses are worth the same amount, the spouse who takes over the former rental pays more tax when they sell than the spouse who takes over the residence.  Exact numbers will depend on circumstances, but the former rental will always be subject to a higher percentage of tax, due to depreciation recapture and the non-qualified rule.

As I said, you might want to have a real professional help you evaluate the situation to see if a monetary adjustment is suggested. 

[Opus 17]

@cofe 

And it should go without saying that whichever spouse takes over the former rental needs full information and copies of depreciation schedules for the property and any improvements that are being depreciated, like a new roof etc., as well as information on any improvements that were made before the home was converted to a rental, because that all affects the cost basis adjustments and capital gains calculation. 

[Mike9241]

if you inquiring about the home sale exclusion once you are divorced, where each of you lives would be your principal residence.   the rules for the home sale exclusion would apply to each.  however, there is a special rule when a rental property is converted into a personal residence.  this can result in a substantially reduce exclusion IRC 121(b)(5). consult your divorce attorney

[Hal_Al]

Q. Are we able to each have one of those homes as a primary residence from a tax perspective?

A. Yes, but, as others indicated, the details are important.  

One it becomes your residence, the mortgage interest and property tax deductions become personal itemized deductions on Schedule A, rather than business (rental) deductions on Schedule E.

The accumulated depreciation goes to the new owner for future tax on sale considerations. 

The new owner will have to live in the home for two years* to qualify for the  home sale exclusion. And the home sale exclusion will have to be prorated (reduced) for the rental time. 

*You might qualify for an exception to the 2 year rule, but the partial exclusion would be reduced further for the actual time of residency. See https://www.journalofaccountancy.com/issues/2009/nov/20091783.html

[Carl]

One thing I want to point out about all the responses on this thread, is that the responders are referring to divorce. The original post says nothing about divorce. Only separation. That makes things much more complex and it matters in what tax year the actual divorce (if any) is finalized.

[Opus 17]

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@Carl wrote:

One thing I want to point out about all the responses on this thread, is that the responders are referring to divorce. The original post says nothing about divorce. Only separation. That makes things much more complex and it matters in what tax year the actual divorce (if any) is finalized.

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Good point.  And California is a community property state (although the marital "community" may end on separation) so you really will need to consult an expert for your tax returns until you actually divorce.  My long answer above assumed you would sell the properties after being divorced, if you sell while still married, that could add complications that I'm not smart enough to predict.