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Following the announcement that Bill and Melinda Gates are splitting after 27 years of marriage, attention now turns to their phenomenal $145 billion fortune. Aside from the obvious emotional aspects and not to mention the mammoth legal challenge ahead regarding the division of assets, the first thing on my mind is, of course, tax. What are the tax implications which need to be considered during the divorce process?
Unforeseen tax implications can have a major impact on clients and there are a surprising number of intricacies surrounding the tax treatment of assets which can often have a bearing on the structuring of the divorce settlement. In this article I have outlined the basic capital gains tax (“CGT”) principles to consider in the process of a divorce and an overview of the tax implications of transferring the main home.
The basic rule is that a transfer of assets between spouses are normally made on a ‘no gain-no loss’ basis for CGT purposes, which means no CGT is due. The recipient simply inherits the base cost of the asset being transferred. However, if spouses have decided to permanently separate, the no gain-no loss treatment for CGT only applies until the end of the tax year of separation.
Finalising a divorce can take a significant amount of time. However, the tax treatment is driven by the intention of permanent separation, not the finalisation of the divorce settlement (or even the actual initiation of divorce proceedings). It is quite common for a married couple to be separated long before the question of formal divorce has ever arisen.
After the tax year of separation, transfers between spouses, either as gifts from one to the other, or by court order, may result in a CGT liability for the transferring spouse as (subject to any reliefs or exemptions) the transfers are deemed to take place at market value, as they are still connected for CGT purposes. This can result in individuals being assessed for CGT on a transfer with no cash exchanging hands. From 6 April 2020, the CGT payment date moved from 31 January following the end of the tax year to 30 days from the date of completion of the transaction. This short 30-day window may prove problematic for individuals who do not have the cash immediately to hand.
Once the couple divorce, they cease to be connected for CGT purposes but if the transfer is ‘otherwise than by way of a bargain at arm’s length’, the general market value rule continues to apply.
Often, following separation, one spouse will leave the matrimonial home and agree to transfer their share to the other spouse who remains. Private Residence Relief (“PRR”) provides an important exemption in such cases.
Where the asset being sold or transferred is (or was) an individual’s primary residence, PRR relieves a proportionate period that the property was occupied as such. Further, the final 9 months of ownership are always covered by the exemption even if the individual has moved out.
Spouses may have only one primary residence between them at any moment. As such, it is common for the leaving spouse to elect another property as their primary residence for PRR purposes once they leave. This can present a problem for the availability of PRR on any subsequent transfer of the marital home.
If a spouse transfers their share in the property to their ex-partner within the tax year of separation, it will be on a ‘no gain, no loss basis’ as described above. This means that the spouse making the transfer will avoid CGT at that time and will be free to claim for PRR on another property.
If the transfer takes place after the tax year of separation, the spouse who has moved out may still claim full PRR relief if the transfer takes place within 9 months of moving out even if they have bought a new house. However, any longer than this and there could be a liability to CGT for the transferor.
If certain conditions are met, it may be possible under a specific statutory provision, for the individual gifting their share to make a claim that the former marital home continues to be treated as their PRR. However, as one of the conditions for this is not giving notice for another home to be their PRR for any part of the period, the claim may not be advantageous and should always be reviewed on an individual basis.
A common situation which arises is where young children are involved and one party wishes to stay in the home but has insufficient assets to buy the other party out. A common arrangement is to own the property by way of trust (known as a Mesher Order). This allows one party to remain in the property with the children, whilst protecting the departing spouse’s interest at the same time.
Under a Mesher Order the family home is ordered to be held by the couple on trust, with the remaining spouse staying in the property until a specified event (e.g. when a child reaches 18). For CGT purposes, there is a disposal into trust by the couple to themselves in their capacity as trustees. This disposal is deemed to take place at market value and provided that not more than 9 months has passed since the departing spouse left the property then PRR should be available in respect of any gain that may arise.
When the Order terminates the trust ends and the order may provide that the house is then to be sold by the trustees. The trustees are entitled to PRR on the entire gain because one spouse has occupied the house as a beneficiary throughout the period of the settlement.
In addition to the legal and financial aspects of separating assets, tax is also a significant issue on separation for those who are married or in a civil partnership and can add unwanted pressure to even the most amicable of splits.
It is important to seek specialist advice to ensure you understand your tax position. We have only summarised the CGT implications in this article but there are other taxes such as inheritance tax and stamp duty land tax, which will need carefully considered as part of a divorce settlement. The timing of separation and seeking tax advice (as well as legal advice) is critical and our team is experienced in dealing with such matters. Contact a member of the tax advice team for more information on divorce and taxation, tailored to your needs.
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