Untangling emotional and financial affairs during a divorce is a messy business. Eddie Chung looks at the potential tax traps for investors who are going through this process
More often than not, divorce is a messy business. Apart from the emotional toll on the parties involved, the job of disentangling a couple’s financial affairs can be complicated and tedious. To add insult to injury, there are a number of tax traps that could render the division of property under a divorce an absolute nightmare.
One of the most common assets that is transferred between parties going through a divorce is their family home. Very often, the home may be in the name of the individual who is exposed to lower risk (eg a stay-at-home parent) or is jointly owned by the couple going through the divorce.
If the home or an interest in the home (assuming that it was purchased after 20 September 1985) is transferred to one of the individuals going through a divorce and the recipient subsequently sells the property, whether or not the sale will attract capital gains tax (CGT) will depend on how the property was used before and after the marriage breakdown.
If the recipient 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 sale. If the recipient rents out the property but does not own another main residence elsewhere, the temporary absence rule may apply – the property may continue to enjoy tax-free treatment for up to six years until the property becomes exposed to partial CGT.
On the other hand, if the recipient nominates another property as their main residence and rents out the old home after the property division, the latter will no longer be covered by the main residence exemption. A special rule will then apply, such that the recipient will be deemed to have acquired the old home at its market value when it first became income producing. 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 sold.
It is important to note that special rules apply if a couple own two dwellings. 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 both properties. However, once the couple have started living permanently separately and apart, each of them may have their own property that is covered by the main residence exemption as if they are unrelated individuals.
While these rules seem relatively straightforward, if the divorcing couple own multiple properties or have used their home for other purposes before the divorce, the tax treatment can become complex and each set of circumstances will need to be carefully considered to determine the correct tax treatment under the main residence exemption rules.
Normally, if an entity transfers valuable assets (eg an investment property) to another entity, the transfer may give rise to CGT, as well as stamp duty, unless a specific exemption can be applied. Between spouses going through a divorce, the transferring party will normally be treated as though they have sold the asset at its market value to the recipient. However, the tax law provides for a CGT roll-over, which basically disregards any capital gain or loss on the asset transfer if the transfer is a result of a marriage breakdown. Similarly, a stamp duty exemption may also apply.
While this may sound sensible and generous, the trap here is that the CGT roll-over only covers the transfer of assets between individuals or from an entity (eg a discretionary trust) to an individual, ie the recipient must be an individual. If a person inadvertently transfers the asset to an entity that is not an individual, the CGT roll-over will not apply and CGT may become payable by the party transferring the asset.
Having said that, while transferring an asset to an individual may make sense for tax reasons, it may not be so for other reasons, for example the recipient may be a high-risk individual who is exposed to litigation risks, so putting an asset into their hands may not be a good move.
An unsuspecting person may think that they could get around the problem by subsequently transferring the asset to, say, a discretionary trust, but the result could be undesirable. For example, if an ex-husband acquired an asset under the marriage breakdown roll-over from his ex-wife, he is deemed to have acquired it at the same cost base as his ex-wife who originally acquired the asset.
By subsequently transferring the asset to, say, a discretionary trust, the transfer may crystallise a capital gain with reference to the market value of the property at the time of the transfer that would otherwise be sheltered by the CGT roll-over if the asset was originally acquired by the ex-wife after 20 September 1985. The only potential relief is that the 50% CGT discount will apply if the asset has been held for at least 12 months, which is counted from the time the ex-wife originally acquired it (rather than from the time when the ex-husband acquired it due to the marriage breakdown) to the time when the asset was subsequently transferred by the ex-husband to the discretionary trust.
For an asset that was originally acquired by the ex-wife before 20 September 1985, the transfer will not give rise to an immediate CGT liability, but the transfer will effectively convert the pre-CGT asset in the ex-husband’s hands to a post-CGT asset in the hands of the discretionary trust.
Another trick to the CGT roll-over is that the asset must be transferred under a formal agreement or settlement (eg pursuant to a court order, maintenance agreement, binding financial agreement, etc.). If the transfer happened as a result of a private agreement that was never formalised under one of the prescribed conditions, the roll-over will not be available, which could entail a prohibitive tax outcome.
The Division 7A rules may give rise to unintended tax consequences in a property settlement due to a divorce.
Broadly, these rules provide that if a private company has a distributable surplus (eg it has retained profits) and makes a payment to an entity who is a shareholder or an associate of a shareholder of the company, the payment will be treated as a taxable dividend. Insidiously, a payment includes the transfer of property.
The Division 7A rules will also apply to a loan provided by a private company that is not repaid by the end of the year, a loan that is forgiven by the company, as well as a right to use an asset that is owned by the company if the economic benefit is provided to a shareholder or an associate of a shareholder of the company.
These Division 7A rules can give rise to some hefty tax traps. For instance, if a private company transfers an asset to a party to a divorce under a formalised agreement (eg court order) and the company has a distributable surplus, the Division 7A rules may inadvertently be triggered, which may give rise to a taxable (but frankable) dividend based on the market value of the asset in the hands of the recipient. When the recipient eventually sells the asset, they will have to pay CGT on any capital gain accrued on the asset from the time it was originally acquired by the company (assuming it was after 20 August 1985) due to the operation of the marriage breakdown roll-over, which will effectively give rise to double taxation!
Similarly, if a party to a divorce is granted a right to use an asset (eg an apartment that was previously rented out) that is owned by a private company, and the party is either a shareholder or an associate of a shareholder of the company, the right to use the asset will be treated as a frankable dividend that will be taxable to the extent that the company has a distributable surplus.
Another common tax trap is that if a private company forgives a loan owed by a shareholder or an associate of a shareholder, the forgiveness may again trigger the Division 7A rules, even though the loan forgiveness is part of divorce proceedings. This will give rise to a taxable dividend to the extent that the company has a distributable surplus, but the dividend will not be frankable in this case. In summary, it is critical that the Division 7A provisions are carefully considered when a divorce settlement is being negotiated. Very often, the fact that the parties can utilise the marriage breakdown roll-over may provide a false sense of security that no other taxation consequences may arise, which is obviously untrue.
Going through a divorce is a time of great turmoil and stress. Apart from having to deal with the emotional issues due to the irreconcilable breakdown of a relationship, the necessity of having to truncate the financial ties of two people is often overwhelming for those individuals involved. Reliable and competent advisers are invaluable resources that will provide some relief in this time of difficulty.
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. The article is provided for general information only and the author and BDO (Qld) Pty Ltd are not engaged to render professional advice or services through this article.