There's no denying that separation and divorce is a difficult path, even if the decision would produce a better outcome for both parties in the long run. More often than not, it is unrealistic to expect that the parties involved will be in a position to think clearly and rationally about the practical issues associated with a divorce, when emotions are running high, and especially if valuable assets such as real property are involved.
Getting it wrong when dealing with the separation of these assets may inadvertently invite a sting in the tail that could cost you more than just emotional heartache and stress.
The main trigger for potential tax issues associated with any divorce is the matrimonial property division process under which the assets of the former couple are split up between them to separate their wealth and affairs from each other going forward.
This process often requires assets or interests in assets to be transferred from one person to the other, which would normally trigger a disposal for capital gains tax [CGT] purposes. To that end, it should be noted that assets owned by a separate entity (eg a company, trust, etc.) that are controlled by the couple but are not in the couple’s own hands are also fair game. They are most likely included in the matrimonial divisible asset pool, which may need to be transferred.
While there is some potential relief provided by the tax law in these circumstances, it would not be terribly helpful if you:
• are unable to negotiate a position that would allow you to utilise the tax relief
• fail to take advantage of the relief altogether, or
• fail to execute the property division properly to satisfy the conditions for the relief
Below, I share some of the issues and tips that may help you avoid these common mistakes, bearing in mind that tailored advice is critical, as everyone’s circumstances are different.
Your family home
If proper structuring advice was obtained and followed when the family home was originally acquired, the property would often be held by the individual who is exposed to lower risks (eg a non-working spouse or de facto spouse). Alternatively, the home may be jointly owned by the couple, either on a 50/50 or disproportionate-ownership basis.
If the home or an interest in the home, assuming that it was purchased after 20 September 1985 and is the family’s main residence, is transferred to one of the individuals as a result of the divorce, the main residence exemption will generally apply and therefore any capital gain derived or capital loss incurred as a result of the transfer will be disregarded.
In some circumstances, the main residence exemption may not fully apply to the transfer. For instance, if the property was originally acquired by the couple as an investment property and was subsequently turned into their home, then an apportioned capital gain may apply. In these circumstances, it may be necessary to apply the ‘marriage breakdown rollover’ to disregard the capital gain.
Assuming that the transferee is an individual and the transferee subsequently sells the property, whether the subsequent sale would attract capital gains tax in the transferee’s hands would depend on how the property has been used after the marriage breakdown.
If the transferee continues to live in the property until it is sold and does not own another home elsewhere, the main residence exemption will continue to apply and the property will not be exposed to any CGT on the subsequent sale.
Also, if the transferee has started renting out the property after the divorce but does not own another home elsewhere, the temporary absence rule may apply. The property may thus continue to enjoy tax-free treatment for up to six years before it becomes exposed to CGT.
On the other hand, if the transferee has started renting out the property after the divorce and owns another tax-free home elsewhere, the property will cease to be a tax-free main residence at this point.
Assuming that the property was never rented out before the divorce, a special rule will apply such that the transferee will be deemed to have acquired the property at its market value when it first became available for rent; this market value will become the cost base of the property for the purpose of calculating the future capital gain on the property when it is eventually sold.
It is important to note that special rules apply if a couple owns two dwellings at the same time. Before they are permanently separated, they may either choose one of the properties as their sole tax-free main residence or nominate both properties as their main residence but claim a partial main residence exemption on each property.
However, once the couple has started living permanently apart in each of the properties, they may begin applying the main residence exemption on the property in which they reside, as they are essentially treated as unrelated individuals once they are separated.
While the rules above seem relatively straightforward, if the divorcing couple owned multiple properties or had used their home for other purposes before the divorce, the tax treatment could become considerably more complex.
Other CGT assets
Under the normal CGT rules, if an entity transfers a valuable asset such as an investment property that was originally acquired by the entity after 20 September 1985 to another entity, the transfer will normally give rise to a CGT event as a result of the asset disposal.
If no consideration is paid on the transfer, or the consideration is more or less than the market value of the asset transferred and/or the parties are not dealing with each other at arm’s length, the market value substitution rule will apply as if the transferor entity has disposed of the asset at its market value for CGT purposes. The transfer may also give rise to stamp duty based on the market value of the asset.
However, if an asset is transferred as a result of a matrimonial property division for no consideration, provided that certain conditions are met, the entity transferring the asset may qualify for a ‘marriage breakdown CGT rollover’, which applies to disregard any capital gain or capital loss that would otherwise be crystallised in the hands of the transferor entity.
If the rollover applies, the transferee spouse acquiring the asset will be deemed to have acquired the asset at the original cost base of the asset previously in the hands of the transferor entity.
Importantly, one of the key conditions for the CGT rollover to apply is that the asset must be transferred under a formal agreement or settlement – for example, pursuant to a court order, maintenance agreement, binding fi nancial agreement, etc.
If the transfer happened as a result of a private agreement between the parties that was never formalised under one of the prescribed conditions, the rollover will not be available, which may give rise to unintended adverse tax outcomes. Professional advice should therefore be sought to avoid such costly mistakes.
Traps for separating couples: CGT
- Capital gains tax is an area that trips many separating couples up, as there are complex rules and laws guiding the amount of tax that will be payable. Generally, the following points need to be considered:
- If an asset is transferred by a transferor entity to a transferee spouse under the marriage breakdown CGT rollover, and the transferee spouse subsequently sells the asset, whether the subsequent sale will qualify for the 50% CGT discount will depend on if the transferee spouse has held the asset for at least 12 months before the sale.
- A special acquisition rule applies to determine if the transferee spouse has held the asset for at least 12 months in these circumstances – the 12-month period is counted from the time when the transferor entity originally acquired the asset to when the asset is eventually sold by the transferee spouse. Therefore, applying this special rule correctly can result in substantial CGT savings.
- While the marriage breakdown CGT rollover may not be too difficult to apply, a technical trap may catch the unsuspecting. The CGT rollover can only apply if the transferee of the asset is one of the divorcing spouses or de facto spouses as an individual.
- This is true irrespective of whether the transferor is an individual or another type of entity (eg a family trust, company, etc).
- If an asset is inadvertently transferred to an entity that is not one of the transferee spouses (eg the transferee spouse’s new discretionary trust), the CGT rollover will not apply and CGT may become payable by the transferor entity.
- While this issue may be resolved by ensuring that the relevant asset is transferred to the transferee spouse as an individual, any subsequent transfer (or sale for that matter) of the asset by the transferee spouse to a related entity to achieve other purposes (eg asset protection) may trigger CGT on the value increase of the asset.
- This will apply on the value difference between what the transferor entity originally paid for it and the market value of the asset when it is ultimately transferred by the transferee spouse to their related entity.
- It should also be noted that the marriage breakdown CGT rollover may apply to an asset that was originally acquired by the transferor entity before 20 September 1985 (ie the asset is a ‘pre-CGT asset’) and was transferred to the transferee spouse under the CGT rollover
- In these circumstances, the transferee spouse will be taken to have acquired the asset before 20 September 1985 as well, so any subsequent sale of the asset by the transferee spouse will not give rise to any CGT.
is a partner, tax and advisory at BDO Queensland