Tax implications of divorce
Divorce? But what about the… tax?!
A consideration of the tax implications of divorce or dissolution of a marriage or civil partnership
When a married couple or civil partners separate or divorce it is likely that the ‘matrimonial’ assets will need to be divided between the divorcing or separating parties - with transfers of assets made to effect the agreed division, potentially giving rise to tax implications. These tax implications will depend upon the point at which asset transfers are made and, to an extent, whether the division of assets has been ordered by the court or made between the parties informally.
In this article, we consider the four main taxes – capital gains tax, SDLT, inheritance tax and income tax – that could arise on or following a transfer of assets in these circumstances; and, in the context of the family home, the extent to which private residence relief may or may not be available on a subsequent sale of the property where one of the owners is no longer in occupation.
Capital gains tax
Transfers of assets between spouses or civil partners do not usually give rise to a capital gains tax (CGT) charge. Instead, the assets are deemed to be transferred on a no gain/no loss basis with the acquiring spouse or civil partner taking over the original acquisition cost. However, this rule only applies to spouses or civil partners that are living together (within the statutory definition) when the transfer occurs.
Spouses and civil partners are treated as ’living together’ for these purposes unless they are separated under a court order or by a formal Deed of Separation, or in such circumstances that the separation is likely to be permanent. Further, the no gain/no loss treatment continues to apply throughout the whole of the tax year in which separation takes place, even though the spouses may not be physically living together at the time of transfer, and can even extend beyond divorce (i.e. to the end of the tax year) in cases where the divorce takes place in the same tax year as separation. The key is therefore the date of permanent separation.
Where transfers of assets between spouses/civil partners take place in the tax year of separation, the transfer should benefit from a no gain/no loss treatment. Where this applies, the transferee spouse will take over the transferor’s original acquisition costs and so will pay CGT on the gain since original acquisition when disposing of the assets.
If, however, the transfer does not occur until after the end of the tax year of permanent separation, there will be a disposal when the transfer takes place, so that the transferor (i.e. the outgoing owner) would be liable to CGT on the gain made between acquisition and the date of the disposal. It is important to be aware that such disposals will be deemed to be made at market value (regardless of the value of any consideration that changes hands), as the divorcing couple will still be ‘connected persons’ up until the date of the decree absolute. The transferee spouse or civil partner would then take on the asset at the market value at the date of the disposal and so, on later sale, would only be liable to CGT on the gain accruing since the deemed date of disposal.
If the transfer takes place following a court order, the date of disposal is the date of the court order, unless that precedes the date of the decree absolute, in which case the date of the decree absolute is the relevant date.
After the decree absolute or dissolution, the former spouses or civil partners cease to be connected persons for CGT purposes, unless they are connected for other reasons, for example as business partners. Transactions between them then take place at the value placed by both parties.
Of course, if the transferred asset was the couple’s main residence, Principal Private Residence Relief may be available to exempt all or part of any gain arising on a disposal made after the year of separation.
The family home and the availability of Principal Private Residence (PPR) Relief
Often, the family home will form a significant part of the divorcing couple’s overall wealth, however, in order for any gain on disposal to be fully covered by PPR relief, any sale or transfer must usually take place within 9 months of the transferring spouse or civil partner leaving the property and it ceasing to be their main residence. In most cases, this will not be possible or practical and it is therefore important to be aware of the potential tax liabilities that may arise when the asset is sold or transferred after this point.
The final 9-month period of absence exemption can be extended indefinitely in some circumstances by making a claim to HMRC, however, all of the following three conditions must be satisfied for this to be possible:
- The transfer must be made under an agreement between the spouses in connection with their permanent separation, divorce or dissolution, or under a court order;
- Throughout the period from the outgoing spouse leaving the property to its transfer or sale, it must continue to be the only or main residence of the other spouse; and
- The spouse who left the property must not have elected for another property to be their main residence for any part of that period.
Careful consideration will therefore be required before any main residence election is made by the departing spouse in respect of any new property and clients should be advised to seek specialist tax advice as early as possible in the divorce or separation process in order to ensure that opportunities for CGT mitigation are not missed.
Stamp Duty Land Tax
There is no general exemption from Stamp Duty Land Tax (SDLT) at the standard rates for married couples or civil partners who transfer property between themselves while ‘living together’ (although there is an exemption from the higher rates for additional properties where the transfer occurs on or after 22 November 2017). However, a transfer of the main residence (or other property) between a divorcing couple will be exempt from SDLT altogether where the transfer has been ordered by a Court or is made in conjunction with any agreement between the parties in contemplation of or in connection with the divorce or dissolution. This is the case whether the transfer is made before or after the divorce and regardless of whether consideration is exchanged.
If there is no such agreement or order, then SDLT will be payable. The tax is based on the consideration given for the transfer, which includes any cash payment and/or any liability assumed for a mortgage debt.
Transfers between UK-domiciled spouses or civil partners are exempt from inheritance tax (IHT), and this continues to be the case throughout the period of separation up until the decree absolute. This is in contrast to the CGT position noted above.
Transfers made after the decree absolute will not be ‘transfers of value’ if they are between, or for the benefit of, the spouses or civil partners and there is no intention of conferring any gratuitous benefit on the recipient. Transfers made following a court order, including the creation of settlements or ongoing maintenance payments to a former spouse or civil partner, are also not usually ‘transfers of value’.
Any other transfers between former spouses or civil partners after Decree Absolute are treated as exempt, potentially exempt or immediately chargeable in accordance with the normal IHT rules.
Despite the fact that married couples and civil partners are taxed independently of each other, there may be income tax consequences of divorce or dissolution of a marriage or civil partnership. For example:
- Where income-generating assets are transferred as part of the divorce settlement, this could affect the income tax status of the transferee spouse or civil partner and potentially move them into a higher tax band;
- If jointly owned assets continue to be owned jointly following the date of permanent separation, income tax liabilities will thenceforth be calculated by reference to the exact percentage of ownership (rather than in equal shares which is the default position for married couples or civil partners unless they have elected to be taxed according to actual beneficial ownership);
- Household income changes could affect eligibility for tax credits or child benefit.
Maintenance payments generally fall outside the UK tax system and so are not taxable on the recipient, but at the same time, they are not tax relievable for the payer.
It will be clear from the above that it will be essential for divorcing or separating clients to seek advice on the potential tax implications at the earliest opportunity – particularly where a transfer of chargeable assets (including the family home) is anticipated. With careful planning, it should be possible to minimise the tax cost of transfers made in connection with the divorce or dissolution proceedings.