Eddie Chung explains how the ‘marriage breakdown roll-over provision’ works and what investors can do to avoid paying hefty capital gains tax during their divorce settlement.
According to the Australian Bureau of Statistics, it is estimated that about every third marriage in Australia ends in divorce.
Whether a divorce is a result of a cordial mutual agreement or bitter saucer-throwing dispute, the process of separation will inevitably involve some kind of asset division. In the absence of special rules in the tax laws, the disposal of interest in an asset by one individual to another could inadvertently give rise to a taxing point (eg, the transfer of a half interest in a jointly owned rental property by one spouse to the other), which could be very costly, especially where real estate is involved, due to its inherent high value. To prevent the tax laws from penalising people who are already going through the emotional trauma of separation and to maintain parity (ie, if an asset is merely transferred for no consideration and there is no cash to fund the tax liability, unlike the scenario of a sale where cash proceeds are received), there exist specific ‘marriage breakdown roll-over’ provisions, which will automatically (ie, it is not a choice) operate to defer the capital gains tax (CGT) that would otherwise be crystallised in ordinary circumstances.
It should be noted that the roll-over provisions apply where ‘spouses’ or ‘former spouses’ are involved. The term spouse is defined to include de facto couples, as well as same sex couples (from 1 July 2009). In other words, the relief will be available even if the couple involved were never legally married.
There are generally two types of roll-overs available. One applies to the transfer of a CGT asset that is owned by an individual to their spouse. Another applies to the transfer of a CGT asset from a company or trustee of a trust to a spouse.
This second roll-over addresses the scenario where a company or trust is used to hold the asset, which is very common for a variety of reasons, eg, asset protection, taxation, etc. For instance, many families use discretionary trusts to own rental properties, especially where the relevant property is cash-flow positive.
However, note that no roll-over is available if the asset is transferred from an individual to an entity. Therefore, if the recipient spouse wishes to further transfer the asset from their own name to say, a discretionary trust, CGT and stamp duty may be triggered, which could effectively undo some or all of the benefits of the roll-over.
To that end, if the asset is already held by an entity, the spouse to whom the asset is transferred may consider assuming control and/or take ownership of that entity, rather than transferring the asset.
For instance, it may be preferable to change the trustee of a trust that owns a rental property such that the recipient spouse will have exclusive control of the new trust. Nevertheless, other issues such as stamp duty will need to be considered.
Type 1: Individual to individual
In the basic scenario where an individual (‘the transferor’) has agreed to transfer, say, a rental property to their spouse (‘the transferee’), the CGT roll-over will be available if the transfer is a result of one of the following:
- a court order under the Family Law Act or under a state, territory, or foreign law relating to breakdown of relationships between spouses
- a maintenance agreement approved by a court under the Family Law Act (or a similar agreement approved by a court under a foreign law)
- something done under a binding financial agreement made under the Family Law Act (or a similar binding written agreement under a foreign law)
- something done under an award made in an arbitration under the Family Law Act or a similar award made in an arbitration under a state, territory, or foreign law
- something done under a written agreement that is binding under a state, territory, or foreign law relating to breakdown of relationships between spouses that, due to such a law, prevents a court from making an order about matters to which the agreement applies (or that is inconsistent with the terms of the agreement), unless the agreement is varied or set aside.
Therefore, if the property is transferred under an informal private arrangement that does not constitute any of the conditions above, the roll-over will not apply, which may trigger hefty CGT consequences in the transferor’s hands.
If the property is transferred under one of the formal conditions as discussed above, the roll-over will apply, which means that any capital gain or capital loss that would otherwise be crystallised will be disregarded.
If the transferor acquired the property before 20 September 1985, the transferee will be taken to have acquired the property before that date as well.
In other words, the roll-over will ensure that the pre-CGT status of the property will be preserved in the transferee’s hands. If the transferee subsequently sells the property, any capital gain derived or capital loss incurred will be disregarded, given the property’s pre-CGT status.
If the transferor acquired the property on or after 20 September 1985, the transferee will effectively inherit the original cost base of the property in the transferor’s hands. In addition, any additional costs incurred in transferring the asset due to the matrimonial asset division, eg, conveyancing costs, stamp duty, etc, will be added to the cost base of the property.
However, any cost that is incurred in relation to general legal advice regarding the matrimonial property settlement is excluded.
Again, the roll-over will operate as if the property was not disposed of, despite the matrimonial asset division, which means that if the transferee eventually sells the property, they will have to pay CGT on the value increase since the property was originally acquired by the transferor.
This potential future CGT may need to be taken into account as part of calculating a fair division of assets based on their values because the transferee may be inheriting a tax liability together with the property upon the transfer, which could mean that the net after-tax value of the property transferred may be less than the actual value intended to be allocated to the transferee.
Nevertheless, it should be noted that, for the purposes of the CGT discount, where an individual who disposes of a CGT asset that has been held for at least 12 months is entitled to a 50% discount, the transferee is entitled to count the 12 months from the time the property was originally acquired by the transferor. Alternatively, the transferee may opt to calculate the CGT under the capped indexation method.
In summary, regardless of whether the property is pre-CGT or post-CGT, the roll-over effectively preserves the time of acquisition and cost base of the asset, which will therefore defer the CGT until it is ultimately disposed of by the transferee.
Type 2: Entity to individual
The conditions for the roll-over relief to apply to the transfer of an asset from a company or trustee of a trust (‘the transferor’) to a spouse of an individual (‘the transferee’) are the same as those applicable to transfers between two individuals, ie, the transfer must be a result of a qualifying court order, a maintenance agreement, a binding financial agreement, an arbitration, or some other written agreement relating to matrimonial breakdowns.
If the roll-over applies, the same consequences applicable to the transfer of assets between two individuals under a valid roll-over will apply.
In other words, if a trustee of a discretionary trust or a company transfers a rental property to a spouse of an individual under the roll-over relief, any capital gain or capital loss that would otherwise be crystallised under normal circumstances will be disregarded.
The transferee will simply inherit the time of acquisition and cost base of the property. If the property is subsequently disposed of by the transferee, the normal CGT rules will apply and any capital gain or capital loss arising from the disposal will be calculated with reference to the inherited time of acquisition and cost base of the property.
For completeness, special cost base adjustment rules will apply if an asset is transferred out of a company or trust to a spouse under the roll-over to reflect the corresponding reduction in value of the relevant interests (eg, shares, units, or loans) in the company or trust. The adjusted cost base will become relevant if say, the shares in the transferor company are subsequently sold by the transferee in future.
It is curious to note that if the property was originally held by a company, which would not have qualified for the CGT discount had the company sold the property without the benefit of any roll-over relief, the CGT discount will become available to the transferee if the marriage breakdown roll-over applies and the transferee subsequently sold the property that was held for at least 12 months since it was originally acquired by the transferor company. While this outcome may be significantly tax beneficial, it is doubtful that anyone would go to the extreme and use marriage breakdown as a means of tax planning!
On a less positive note, the tax law currently contains a rather insidious sting if an asset is transferred out of a related company to a spouse and the company has a ‘distributable surplus’, despite the operation of the roll-over relief. Under the deemed dividend provisions (commonly known as ‘Division 7A’), a transfer of an asset to a shareholder or an associate of a shareholder of a company may give rise to a deemed dividend in the hands of the transferee.
For instance, if a company, which has distributable surplus, is wholly owned by an individual and, as part of a property settlement, the company transfers a rental property to the individual’s spouse under the roll-over, the spouse will be taken to have derived a Division 7A deemed dividend, which will be assessable income in their hands! To make things worse, given that there is no corresponding adjustment to the cost base of the property under the current law, double taxation will arise when the spouse eventually sells the property.
For completeness, neither the transfer of the family home (provided that it has not been used for other purposes) nor the transfer of cash as part of the property settlement will give rise to any CGT consequences.
Divorce and separation are times of enormous stress for most people and it is difficult for those involved to have the right frame of mind to deal with practicalities such as property and taxes.
While most people will instinctively engage a lawyer to assist them with the legal aspect of the matrimonial proceedings, it is highly advisable that an experienced tax advisor be engaged as well, especially where the assets involved are substantial in value. The tax advisor and lawyer should then work together to safeguard and maximise their client’s interest.
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