The word "divorce" is something that we generally try to avoid. It is not a pleasant topic. But if you and your spouse own a home, you must do some careful tax planning as early as possible, indeed immediately after the parties begin to realize that divorce is inevitable.

Your house is probably your largest asset. You would like to keep it or -- if it has to be sold -- you want to pay as little tax as possible.

Under current tax law, married taxpayers can completely exclude from taxation up to $500,000 of any profit they make when the house is sold, so long as during the past five years prior to sale (1) they both lived in the house for at least two years and (2) at least one spouse owned the home for at least two years. The IRS calls this the "ownership and use" test. Congress decreed that married couples -- who meet the use and the ownership tests -- could save up to $500,000 of their gain. Single people, however, or taxpayers filing a separate tax return, could only save $250,000 of gain. How does this impact on the divorcing couple? Let us look at the following example:

Several years ago, a husband and wife bought a house for $200,000; it is now worth approximately $500,000. They have three children in their early teens, who want to stay in the house until they complete high school. The husband has agreed to move out, but the wife will stay in the house at least until the children reach age 18. (It must be pointed out that neither the law nor this columnist has a gender bias, and thus is applicable regardless of which spouse stays in the house.)

In some situations, the husband will agree, pursuant to a divorce settlement agreement, to immediately transfer his one-half interest in the property to the wife. Alternatively, they may agree that the husband will retain ownership of his share of the property until some later time when it is sold, at which time any profits will be distributed pursuant to their Divorce Separation Agreement.

It is important to consider the tax implications for both scenarios. Where the husband transfers his share of the house [we'll presume it to be a 50 percent interest] to the wife, under certain circumstances the law treats this as a nontaxable event. Since 1984, under section 1041 of the Internal Revenue Code, any transfer of property between spouses or former spouses is considered non-recognized gain. The transfer has to be during the marriage, or as an "incident to a divorce."

The concept of "incident to a divorce," is very significant. According to Section 1041 of the Internal Revenue Code, a transfer of property is incident to the divorce if such transfer:

• Occurs within one year after the date on which the marriage ceases, or

• Is related to the cessation of the marriage.

The IRS has taken the position that if the transfer is specifically spelled out in the divorce or separation agreement, it is incident to the divorce only if the transfer occurs within six years after the date on which the marriage ends.

It should be noted that this non-recognition of gain concept is not available for transfers to spouses (or former spouses) who are nonresident aliens.

On the other hand, for transfers that are not made under a divorce or separation instrument, or that do not occur within six years after the end of the marriage, there is a presumption that the transfer was not related to the ending of the marriage. This is a presumption that can be overcome, if the parties can demonstrate facts to support the position that, in fact, this was really part of their divorce obligations.

In our example, the property was purchased for $200,000. Assuming no improvements were made to the property, the husband's basis in the property is $100,000. If the husband were to transfer his one half interest in the property to the wife, he would have no taxable consequences. The wife, on the other hand, would pick up the husband's basis in the property ($100,000), and her basis would thus become $200,000.

When the wife later sells the property she alone will pay tax on the gain from the sale. The amount of gain will be calculated by subtracting her basis in the property ($200,000 in our example) from the selling price of the house. If the value is still $500,000, she will realize gain in the amount of $300,000.

But since her husband no longer owns or lives in the property, she will be considered a single tax filer, and -- assuming she has met the use and ownership requirements) -- she will only be eligible to exclude $250,000. She will have to pay capital gains tax on the difference, which is $50,000. Under current tax laws, in most cases (depending on her income) the capital gain tax will be 15 percent, and this will result in a federal tax in the amount of $7,500. And we cannot ignore any state income tax which she will have to pay.

Instead of the husband transferring his interest to the wife, the parties may agree that the husband will remain a co-owner of the property and will receive half -- or some agreed upon portion -- of the sales proceeds when the property is sold. The tax benefits of this arrangement can be significant.

Even though the husband no longer lives in the property, so long as the wife has been granted use of the property under a separation agreement or divorce decree, and they meet the other tests for the exclusion (i.e. use and ownership), up to $500,000 of gain can still be excluded from tax. This is because of a special rule under I.R.C. Section 121 that treats the husband as using the property as his principal residence during any period that the former wife uses the property as her principal residence. The rule only applies, however, if the husband still owns the property. In addition, the wife's entitlement to use it must be set forth in a separation agreement or divorce decree.

In our example, if the husband remained a co-owner of the property when it sold for $500,000, all $300,000 of the gain would be excluded from income. If the property is not sold until after the children move out and the property has appreciated beyond its $500,000 value at the time of the divorce, all of the additional gain would be excluded up to $500,000.

The most tax effective route is for is for both husband and wife to stay on title until the house is sold. This way they can take advantage of the full $500,000 exclusion, especially since real estate has appreciated dramatically in the past few years.

However, there are other factors -- other than tax -- that come into play when there is a divorce. The spouse using the property may not want to have a fixed date for selling and moving out of the property. Conversely, the other spouse may not want (or be financially able) to have an open-ended agreement as to the time for sale. For example, if the husband moves out of the house, but remains on title to the property with his wife, he may have a difficult time getting a new mortgage loan should he ever decide to buy another property in which to live.

Thus, husbands and wives who are in the process of separation must look carefully at the taxable consequences on how to deal with the house they own. If one spouse moves out and can no longer claim the family home as the principal residence, be prepared to pay the tax if there has been considerable appreciation of the family home. And, perhaps of most importance, make sure that your legal documents comply with the applicable federal tax laws. As with any tax issue, if you are not clear on the law, consult your financial and tax advisors.