How divorcing couples are affected by tax
For couples facing divorce, the tax consequences of their financial settlement are unlikely to be at the forefront of their minds.
This blog post was first published in the FT Adviser and can be accessed here.
Nevertheless, the implications of failing to take good tax advice can have a significant impact on a couple's finances at a time at which they are likely to be under pressure anyway. Changes being made to aspects of the capital gains tax regime with effect from 6 April 2020 may also affect the tax analysis. Thus, anyone considering separation or divorce should seek tax advice as early as possible. Specialist advice should always be taken where one or other party is domiciled outside the UK.
Please note that we refer throughout this article to spouses, but all the issues touched on apply equally to civil partners.
Capital Gains Tax
The most significant tax consideration in the context of separation or divorce is likely to be a potential capital gains tax (CGT) liability when assets are sold or transferred from one spouse to the other as part of a financial settlement. For many couples, the marital home is likely to be the most valuable asset to be considered in a divorce, but other assets and investments, including second homes, may also be significant in any financial settlement.
Outright transfer between spouses
Timing is the key here.
Assets of all types that are transferred between spouses during a tax year in which they have lived together at some point, pass on a "no gain, no loss" basis, so the recipient spouse is treated as receiving the asset at the value at which the transferring spouse acquired the asset.
However, if such a transfer takes place in a tax year after the couple has formally separated, assets will be treated as passing at market value, and accordingly any gain in value since acquisition will be taxable on the transferring spouse, subject to any available relief. This is despite the fact that there may have been no financial consideration involved from which the tax might otherwise be paid.
As the CGT liability arises to the person disposing of the asset (the transferring spouse) one might argue that the recipient spouse has little interest in timing the transfer to avoid a CGT charge. However, it is generally in the interests of both spouses to minimise the tax payable in order to maximise the pool of funds available to be shared between them.
While tax will not be the only relevant issue, if it is possible to ensure that any transfer of assets between spouses is made in a tax year in which they have lived together, in most cases this is likely to be preferable. If not, then negotiations of any financial settlement should always take into account any prospective CGT liability of either or both spouses, in respect of transfers of assets between them.
Principal Private Residence Relief for the family home
In the case of a couple's main residence, Principal Private Residence Relief (PPR) may be available to exempt any gain arising after the year of separation.
However, for PPR to apply to the full gain, any sale or transfer must take place within 18 months of the transferring spouse leaving the property and it ceasing to be their main residence. The 18-month period of absence will reduce to nine months with effect from 6 April 2020, which will make the timing even tighter to secure full PPR for the departing spouse.
This period of absence can be extended indefinitely under relevant CGT legislation if the disposal of the property is to the former spouse, and the following three conditions are satisfied:
- The transfer is 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 individual leaving the property to its transfer or sale, it continues to be the only or main residence of the other spouse; and
- The individual who left the property has not elected for another property to be their main residence for any part of that period. These will include a change to lettings relief, which in future will be available only to property owners living in a property while it is rented out.
The third condition is the one most likely to prove to be a stumbling block, as it will not always be advisable for the non-occupying spouse to forego PPR on any new main residence. There are a couple of other changes to the ancillary rules for PPR due to take effect from 6 April 2020 that may affect the tax analysis in certain circumstances in respect of any transfer of the family home.
A second proposed change aims to ensure that where a transfer takes place under the no gain no loss rule, the recipient spouse always inherits the full history of ownership of a property from a transferring spouse for the purposes of calculating PPR. As a result, in certain situations, full PPR could be claimed on a subsequent sale of a property by the recipient spouse, despite the fact that the property might, for example, have been a buy-to-let property for years in the transferring spouse's hands. PPR is not available for transfers of second homes, and the only relief from CGT in this case, or in respect of other non-business assets, would be the individual's annual exemption (£12,000 in tax year 2019/20), if available.
Deferred trust of land
Courts do not always order an outright sale or transfer of the family home.
Instead a "Mesher" or "Martin" order may be made, whereby the property is held in both parties' joint names on trust until a specified event occurs, for example (in the case of the former) the youngest child reaching 18 or leaving education. Until that point, the occupying spouse has the right to reside in the property.
For tax purposes, the two spouses are regarded as making a disposal into trust at the date of the court order in respect of which PPR is available. When the property is later sold, provided the conditions to extend the period of absence apply, PPR should be available to the non-occupying spouse, if he or she wishes to claim it, regardless of the period that may have elapsed since he or she left the property.
From an IHT perspective, the creation of a trust under either a Mesher or Martin order should have no immediate adverse effects provided it is entered into before the decree absolute or dissolution order.
However, IHT is discussed further below.
A deferred charge differs from a Mesher or Martin order in that the property moves into, or remains, in the sole ownership of the occupying spouse.
The interest of the non-occupying spouse is represented by a charge over the property. This charge is enforceable on the occurrence of a specified event, again likely to be the youngest child reaching 18 or leaving education. The charge is either a percentage of the eventual sale price or a fixed sum.
Generally, a percentage is considered preferable in order to permit the non-occupying spouse to share in any increase in value of the property in the intervening period. The CGT analysis will vary according to the alternative chosen and tax advice should be taken before any decision is made.
For most couples, the inheritance tax (IHT) implications of divorce are limited, as any transfer of assets between them should be covered by the spouse exemption, provided it is made before decree absolute or a dissolution order.
Even after that event, transfers are likely to escape an IHT charge on the basis that they are not intended to confer gratuitous benefit, for example, because they take place as a result of a court order or compromise agreement between the parties. However, where an ongoing trust is created, including a deferred trust of land depending on its terms, there may be a risk of future IHT charges arising.
Therefore, it is important that IHT advice is always taken as part of any financial settlement. For couples where one spouse is UK domiciled and the other is not, the spouse exemption is limited to £325,000 (in tax year 2019/2020) for transfers from the UK domiciled spouse to the non-UK domiciled spouse.
Any sum transferred in excess of that amount will be treated as a "potentially exempt transfer" and will also be exempt from IHT provided the transferor spouse survives for seven years following a transfer. Taper relief is available to reduce IHT liability in respect of transfers made between three and seven years prior to the death of the transferor.
While the IHT implications of separation or divorce itself may be limited, once any financial settlement is finalised, both parties should take their own estate and tax planning advice to ensure that their wills and other financial arrangements are updated to reflect their new status and to be as tax-effective as possible.
As married couples are taxed separately on their income, the tax implications of divorce are generally limited to any income-producing assets that are transferred as part of the financial settlement. However, everyone's circumstances vary, and it is important always to take advice.
Stamp duty land tax
Stamp Duty Land Tax may be payable on transactions involving land, including the purchase of a residential property.
Transactions in connection with divorce or dissolution of civil partnerships and made in pursuance of a court order of divorce, dissolution or separation are generally exempt from SDLT. This would include transfers of the family home between spouses.
However, SDLT will be payable on acquisition of any new residential property, for example if the non-occupying spouse decides to buy a new property in which to live. In normal circumstances, the acquisition of a property (or "dwelling") while also retaining an interest in another one (for example, in the family home) would give rise to an additional SDLT charge at the rate of 3 per cent of the value of the property.
This charge would be payable in addition to the standard rates of SDLT. However, where a couple is getting a divorce, a spouse who owns an interest in a dwelling in respect of which a property adjustment order has been made for the benefit of another person is not treated as owning that interest for the purposes of the additional charge, provided that the dwelling is not his or her main residence, but it is the other person's main residence.
This article has touched on some of the most common tax considerations for couples considering separation, divorce or dissolution of a civil partnership, and while not exhaustive, this should illustrate the vital importance of taking tax advice at the earliest opportunity in order to ensure that adverse tax consequences are avoided or mitigated as far as possible.