Do I Pay Taxes on a Home Buyout After Divorce?

The cash that changes hands in a home buyout after divorce is not taxed as income to either spouse. Federal law treats the transfer as a property division rather than a sale, so the spouse receiving the money owes nothing to the IRS on it.¹ The tax bill shows up later, and it falls almost entirely on the spouse who keeps the house. That spouse inherits the couple’s old cost basis, which is often far below what the home is now worth, and the deferred gain waits there until the home is sold.

Why the Buyout Itself Isn’t Taxed

Section 1041 of the Internal Revenue Code says no gain or loss is recognized when property moves between spouses, or between former spouses if the transfer is incident to the divorce.¹ The IRS treats the transaction as a gift for tax purposes, no matter how much money changes hands. The spouse who walks away with cash does not report it as income. The rule is mandatory, with only narrow exceptions such as transfers involving a nonresident alien spouse or certain trusts.²

A transfer qualifies automatically if it happens within one year after the marriage legally ends.¹ Most buyouts close within that window. Transfers made later can still qualify if they are made under the divorce decree or separation agreement and happen within six years of the marriage ending.³

The Carryover Basis Problem

The spouse who keeps the home does not get a fresh cost basis equal to what they paid in the buyout. They inherit the same adjusted basis the couple carried before the divorce.¹ The tax-free treatment on the front end is really a deferral, and the whole deferred gain shifts to the spouse holding the asset.

Adjusted basis starts with the original purchase price, adds capital improvements such as a new roof, kitchen renovation, or addition, and subtracts casualty losses and any depreciation previously claimed.² The buyout payment does not increase basis at all.

An example makes the size of this clear. Say the couple bought the home for $200,000 and put $50,000 into improvements, for an adjusted basis of $250,000. The home is now worth $600,000. The retaining spouse pays a $175,000 buyout for the other half of the equity. Their basis stays at $250,000, not $600,000. If they later sell for $650,000, the gain before any exclusion is $400,000.

Records matter more than people expect. Keep the original closing statement, receipts for every improvement, and any documentation of insurance claims or depreciation. You’ll need them to report the eventual sale on Form 8949 and Schedule D.⁴

Using the Principal Residence Exclusion

Section 121 is the main tool for cutting the eventual gain. A single filer can exclude up to $250,000 of gain on the sale of a principal residence; a married couple filing jointly can exclude up to $500,000.⁵ You must have owned and used the home as your primary residence for at least two of the five years before the sale.⁶ The exclusion can only be used once every two years.

If You Keep the Home

The retaining spouse usually has the larger deferred gain because of the carryover basis. They can claim the $250,000 single-filer exclusion when they sell, and meeting the two-year use test is generally not a problem since they’re still living there. The $500,000 exclusion is not available unless they remarry and the new spouse also meets the use requirement.⁵

Applied to the earlier example, a $400,000 gain minus the $250,000 exclusion leaves $150,000 taxable at long-term capital gains rates. High earners may also owe the 3.8% net investment income tax on capital gains once modified adjusted gross income crosses $200,000 for single filers or $250,000 for joint filers.⁷

If You Move Out

Divorce creates an obvious problem with the two-year use test for the spouse who leaves. Congress addressed this directly. If the divorce decree grants your former spouse use of the home, the time they spend living there counts as your own use for purposes of the exclusion.⁵ That preserves the moving spouse’s $250,000 exclusion if the home is later sold rather than bought out. The arrangement has to be spelled out in a divorce or separation instrument.⁸

Partial Exclusion for an Early Sale

Sometimes divorce forces a sale before either spouse hits the full two-year mark. Divorce qualifies as an unforeseeable event under IRS rules, which allows a partial exclusion. Divide the time you actually owned and used the home by 730 days or 24 months, then multiply by $250,000. Eighteen months of use produces a maximum exclusion of $187,500.⁸

The Mortgage Doesn’t Follow the Deed

This isn’t a tax point, but it derails buyouts often enough that it belongs in the same conversation. Signing a quitclaim deed transfers ownership of the property. It does nothing to the mortgage. If both spouses signed the original loan, both remain legally responsible for it until the loan is refinanced or paid off. The lender is not bound by the divorce decree.

Federal law does protect the transfer itself. The Garn-St. Germain Act prevents lenders from calling the loan due when a home is transferred to a spouse under a divorce decree or separation agreement.⁹ So the retaining spouse can take title without the lender demanding full repayment. Protection from the due-on-sale clause is not the same as being released from the debt, though. Until the loan is refinanced in the retaining spouse’s name alone, missed payments hit both spouses’ credit and the lender can pursue either borrower for the full balance.

The practical move is to negotiate a refinancing deadline into the settlement, often 90 to 180 days, with a forced sale as the fallback. If the retaining spouse cannot qualify to refinance on their own, that is a warning about the buyout structure itself.

Trading House Equity for Retirement Money

A common arrangement gives one spouse the house and the other a larger share of a retirement account. The math is trickier than it looks because these assets are not taxed the same way.

Home equity is a post-tax asset. Income tax was already paid on the money that funded the down payment and mortgage payments. A traditional 401(k) or IRA holds pre-tax dollars, and every dollar withdrawn is taxed as ordinary income at rates that can run 22% to 37% depending on the bracket. Swapping $200,000 in home equity for $200,000 in a traditional 401(k) is not an even trade. That retirement balance might be worth $130,000 to $156,000 after tax.

If the settlement splits a 401(k) or other employer-sponsored plan, a Qualified Domestic Relations Order tells the plan administrator to pay a portion to the non-participant spouse. Distributions from employer plans made under a QDRO are exempt from the 10% early withdrawal penalty that normally applies before age 59½. The money is still taxed as ordinary income, but avoiding the penalty is meaningful if the receiving spouse needs cash to fund the buyout. This penalty exception applies to employer-sponsored plans, not IRAs. If retirement funds are rolled into an IRA first and then withdrawn, the 10% penalty comes back.¹⁰

State Transfer Taxes and Recording Costs

Federal income tax is not the only cost. Deed transfers can trigger state and local transfer taxes, documentary stamp taxes, and recording fees. Rates vary widely, from fractions of a percent to over 2% of property value in some states, with higher figures in a few jurisdictions.

Many states exempt transfers between divorcing spouses from transfer taxes because the transaction is a property division rather than an arm’s-length sale. Claiming the exemption usually means submitting the recorded deed with a copy of the divorce decree or a specific exemption affidavit to the county recorder. Without that paperwork, the recorder may treat the transfer as a taxable sale.

Recording fees for filing the new deed generally run from $10 to $100 depending on the county. A professional appraisal, if one is needed to set the buyout figure, typically costs $575 to $1,300 for a single-family home. These are small numbers next to the buyout itself, but the settlement agreement should spell out who is paying them.

1
Office of the Law Revision Counsel. 26 USC 1041 – Transfers of Property Between Spouses or Incident to Divorce
2
Internal Revenue Service. Publication 504, Divorced or Separated Individuals
3
GovInfo. 26 CFR 1.1041-1T – Treatment of Transfer of Property Between Spouses or Incident to Divorce
4
Internal Revenue Service. About Form 8949, Sales and Other Dispositions of Capital Assets
5
Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence
6
Internal Revenue Service. Sale of Your Home
7
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
8
Internal Revenue Service. Publication 523, Selling Your Home
9
Office of the Law Revision Counsel. 12 USC 1701j-3 – Preemption of Due-on-Sale Prohibitions
10
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions