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How can a divorcing couple work the capital gains exclusion to their advantage?

First, by filing a joint return. When both spouses agree to use the house as the principal residence for two years, the $500,000 may be preserved. But if neither spouse agrees to continue to use the house until one of the spouses reach the two-year mark, $250,000 exclusion moves to zero.

Even within this, however, there are ways to use the exclusion that are not immediately apparent. For example, if two divorcing spouses cannot, for one reason or another, file a joint return, the house may be sold to each of them as tenants in common, then each may be able to report a gain on a separate return up to $250,000.

Moreover, the use may also include the period of time a spouse owns but does not use it, particularly when a spouse or former spouse is granted use of it by the provisions of a divorce or separation instrument. In this case, the period of use by the house-occupying spouse may be counted as use to time credited to the non-occupying spouse. (Here the term separation instrument means "virtually any written agreement involving spousal separation in a divorce setting.")

For example, suppose Rufus and Rhonda buy a house and file for divorce shortly thereafter. If Rhonda moves out but Rufus remains in the house, Rhonda may consider herself living in the house as long as Rufus lives in the house, and as long as he lives there two years, each of them is entitled to the $250,000 exclusion as long as both of them continue to own at least part of the house.