In this blog, we compare the capital gain exclusions in the United States and the United Kingdom that are available for taxpayers selling a personal residence.
Given the full exclusion in the UK and the limited exclusion in the US, US citizens living in the UK should be mindful of the ramifications of this significant difference when selling their home.
In light of the complexities associated with a house sale as part of a divorce, we’ve included discussions of the US and UK rules in this context as well.
Home Sale in the United Kingdom
Under UK law, you do not pay capital gains tax when you sell (or ‘dispose of’) your home if all of the following apply:
- you have one home and you’ve lived in it as your main home for all the time you’ve owned it
- you have not let part of it out - this does not include having a lodger
- you have not used a part of your home exclusively for business purposes (using a room as a temporary or occasional office does not count as exclusive business use)
- the grounds, including all buildings, are less than 5,000 square meters (just over an acre) in total
- you did not buy it just to make a gain
If all these apply, you will automatically get a tax relief called Private Residence Relief (“PRR”) and will have no tax to pay. If any of them apply, you may have some tax to pay.
In the case of a separation and divorce, complexities can arise.
Before separation, spouses are treated as having only one main residence between them for PRR. They cannot each nominate a different home. The moment spouses permanently separate, the rule that they must share a single main residence stops applying. If one spouse moves out and buys or rents a new home, that new home can qualify as their main residence for PRR. The spouse who remains in the former marital home continues to get PRR.
In the case that one spouse moves out of the marital home, then if the spouse who moved out transfers their share of the former home to the spouse who stayed, the departing spouse can claim PRR up to the date of transfer (even if they moved out years earlier), as long as the property remained the other spouse’s main residence.
If the marital home is sold to a third party (not transferred between spouses), then the spouse who stayed gets full PRR, but the spouse who moved out gets PRR for the period they lived there (plus the additional 9 months). As such, if the sale were to happen years after separation, the spouse who moved out may owe capital gains tax.
Home Sale in the United States
Under US law (IRC Section 121), gain from the sale of property (including an interest in the property), including non-US property, can be excluded for federal income tax purposes, in an amount up to $250,000 ($500,000 for married couples filing jointly) if, during the 5-year period ending on the date of the sale, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.
The $250,000 limitation is a critical factor many expats overlook. As an example, if a US citizen living in the UK sells his personal residence, generating a profit of $400,000, such profit would likely be tax exempt in the UK, but would be subject to tax in the US on the difference between the gain and the exclusion (i.e., $150,000 gain).
If the sale occurs before meeting the two-year requirement due to a change in employment, health, or unforeseen circumstances, a prorated exclusion may be available.
If the property was used as a rental or for business purposes, special rules apply:
- Any gain attributable to depreciation claimed for periods when the property was rented or used for business cannot be excluded and must be recognized as taxable gain (subject to a maximum 25% capital gain rate).
- If the property was rented out for a period, but the taxpayer still meets the two-out-of-five-year ownership and use test, the exclusion is generally available, except for the depreciation recapture described above.
- If the property was not used as a principal residence for a period (i.e., "nonqualified use"), the gain attributable to that period is not eligible for exclusion. The amount of gain allocated to nonqualified use is calculated as a fraction: (nonqualified use period) divided by (total ownership period), multiplied by the total gain (excluding depreciation recapture).
- "Nonqualified use" does not include any period after the last date the property was used as a principal residence (e.g., if you move out and then rent the property before selling, that rental period is not counted as nonqualified use for this purpose).
In the case of a divorce, each former spouse is generally treated as a separate taxpayer for purposes of principal residence exclusion. Each may claim up to a $250,000 exclusion on their share of the gain, provided they meet the ownership and use requirements.
If a taxpayer receives the residence from a spouse or former spouse in a transfer incident to divorce, then the recipient’s period of ownership includes the period the spouse or former spouse owned the property. This means the recipient can "tack on" the former spouse’s ownership period to meet the 2-year ownership requirement.
If, under a divorce or separation instrument, one spouse or former spouse is granted the right to use the home, the non-occupant spouse is treated as using the property as a principal residence during any period that the other spouse/former spouse is granted use of the property and actually uses it as a principal residence. This allows the non-occupant spouse to meet the 2-year use requirement even if they moved out, as long as the other spouse/former spouse continues to use the home as a principal residence under the divorce or separation instrument.
