Divorce, S1 and S2 grant S2 and kids K1 and K2 home as tenants in common (TIC) for $1. S2 is only resident. TIC agree to sell. Tax implications for K1 and K2 on sale?

@Critter-3 

Normally, property transfers as the result of a divorce are not taxable to either party.  However, by giving a share of the home to the kids, it's a bit more complicated.  You should get professional advice.

Let's run through a couple examples so you know what to ask your professional.

Suppose S1 and S2 bought the home together, and S1 transfers ownership to S2.  S1 also transfers their cost basis.  Cost basis is the original cost of the home, plus the cost of permanent improvements.  S2 sells the home and is required to pay capital gains tax on the gain, which is the difference between the selling price and the cost basis.  This is all discussed here.  https://www.irs.gov/forms-pubs/about-publication-523

As long as S2 owned and lived in the home at least 2 years (including before the divorce when S2 was a part-owner), S2 can exclude the first $250,000 of capital gains from taxation.

Example 1: S1 and S2 bought the home in 2015 for $100,000.  In 2018, they replaced the roof for $15,000.  They divorce in 2020 and S2 becomes sole owner.  The home is sold in 2022 for $350,000.  The capital gain is $350,000 minus $115,000 = $235,000.  Because the gain is less than $250,000, none of it is taxable.

Example 2: The facts are the same except the home sells for $400,000.  The capital gain is $285,000.  S2 can exclude $250,000 of gain from taxation and the remaining $35,000 is taxed as a long term capital gain.

However, part of the home was apparently gifted to the children.  In addition to possibly requiring the filing of a gift tax return (but no payment of actual gift tax), this could significantly change the capital gains calculation depending on how long ago this happened.

Example 3: S1 and S2 bought the home in 2015 for $100,000.  In 2018, they replaced the roof for $15,000.  They divorce in 2020 and S2 becomes sole owner on 7/1/2020.  The home is sold on 8/1/2022 for $350,000.  The capital gain is $350,000 minus $115,000 = $235,000.  Each co-owner (S2, K1, K2) reports the sale on their personal tax return, using 1/3 the cost basis and 1/3 the selling price.  In other words, each co-owner reports a cost basis of =$38,333,  a selling price of $116,666, and a capital gain of $78,333.  Because each co-owner was a co-owner and a resident of the home for more than 2 years, they can each exclude up to $250,000 of the gain.  Since the gain is less, none of the gain is taxable to any co-owner.

Example 4: However, suppose the divorce happened less than 2 years before the sale, so the children did not co-own the property for more than 2 years.  S1 and S2 bought the home in 2015 for $100,000.  In 2018, they replaced the roof for $15,000.  They divorce in 2020 and S2 becomes sole owner on 7/1/2020.  The home is sold on 4/30/2022 for $350,000.  The capital gain is $350,000 minus $115,000 = $235,000.  Each co-owner (S2, K1, K2) reports the sale on their personal tax return, using 1/3 the cost basis and 1/3 the selling price.  In other words, each co-owner reports a cost basis of =$38,333,  a selling price of $116,666, and a capital gain of $78,333.  Because S2 owned and lived in the home more than 2 years, S2 can exclude up to $250,000 of capital gains.  However, because K1 and K2 did not own the home more than 2 years (even though they lived there), they don't qualify and the entire $78,333 capital gains is taxable to them.

If K1 and K2 did not live in the home more than 2 of the past 5 years (such as, they grew up and moved away), they don't qualify for the exclusion even if they owned the home more than 2 years.

There is also a hardship rule that may allow the children to exclude part of their gain even if they don't meet the 2 year ownership rule. This is also covered in publication 523.

This covers the basics, and should help you ask knowledgable questions of your expert.