man-woman-not-speaking-divorce

Read Part 2 of this series here. Editor’s note: While this article was published in 2013, the author has confirmed that it is current for the 2016 tax year.

When clients separate or divorce, they may not think about taxes when dividing property.

Yet the impact of income taxes shapes the size and type of assets that are transferred between spouses. So, carefully consider them when splitting assets as part of an equalization payment.

Read: Spousal support: Financing togetherness

Property transfers

The settlement in a divorce or separation often requires transferring assets between spouses or common-law partners.

For income tax purposes, the transfer of assets such as non-registered financial investments (shares of private or public companies, mutual funds, etc.) or real estate (including a matrimonial home or recreational property) generally takes place at the adjusted cost base (ACB), meaning no tax is triggered when an asset is transferred between spouses. This is often referred to as a rollover.

Read: Capital gains mean tax-efficient investing

The recipient of an asset is generally taxed at the time he or she ultimately sells or disposes of the asset (including a deemed disposition upon death) based upon the difference between the ACB of the asset and its fair market value at the time of transfer.

This tax-deferred rollover provision applies automatically unless the parties decide to transfer an asset at its fair market value, thereby triggering a capital gain upon transfer.

This election would benefit the transferring party if he or she has unused capital losses available to offset those capital gains.

Read: Divorce in the digital age

Example

Tom plans to transfer to Katie a $100,000 non-registered mutual fund portfolio due to their marriage breakdown. Tom purchased the funds a number of years ago and has an adjusted cost base (ACB) of $50,000. Tom also has unused capital losses from previous years of $50,000.

With no tax planning, the transfer will occur at Tom’s ACB ($50,000), which will result in no immediate tax liability for Tom. Katie will inherit Tom’s ACB upon the transfer and thus own the $100,000 portfolio with an ACB of $50,000.

Assuming Katie sells the portfolio in the future for $120,000, she will incur a tax liability of approximately $15,750, assuming a 45% marginal tax rate ($120,000 – $50,000 x 50% inclusion rate x 45% tax rate).

Read: Claim the capital gains exemption

However, if Tom files an election to not have the automatic rollover provisions apply, he can transfer the mutual fund portfolio at its current fair market value ($100,000) and trigger the $50,000 capital gain.

Since he has unused capital losses, he can apply them against this gain and the result again would be no taxation.

That also means Katie will inherit the portfolio with an ACB of $100,000 (instead of $50,000). When she sells the portfolio in the future for $120,000, her tax liability will be reduced to $4,500 ($120,000 – $100,000 x 50% inclusion rate x 45% tax rate).

RRSP and RRIF transfers

If some or all of the amounts in an RRSP or RRIF are being transferred between spouses or common-law partners as a result of separation or divorce, the transfer can take place on a tax-deferred basis on two conditions:

  • the money being transferred remains in a RRSP or RRIF of the recipient spouse or partner, and
  • the transfer is done pursuant to a court order or written separation agreement using CRA form T2220.

When the recipient spouse or common-law partner later withdraws money from his or her RRSP or RRIF, the full amount is taxable in that person’s hands at their marginal tax rate in the year of withdrawal.

Read: Best ways to mature RRSPs

So, in some cases it makes sense to transfer some or all of an RRSP or RRIF as part of equalization between spouses on relationship breakdown.

Specifically, RRSP transfers are a preferable way of satisfying equalizing obligations when there is a dramatic difference between the marginal tax rates of the spouses, particularly where the recipient spouse intends to draw income from the RRSP or RRIF at a future time when his or her taxable income is lower.

Frank Di Pietro, CFA, CFP, is assistant vice-president of tax and estate planning at Mackenzie Investments. He can be reached at fdipietr@mackenzieinvestments.com.
Originally published on Advisor.ca
See all comments Recent Comments

Rob

I have a question about future disposition costs. Let’s say a man owned a rental property prior to marriage. During marriage the value went up by $200,000 and then they separated. To make things simple let’s say he owes the wife half that amount in equalization – $100,000. He plans to pay her out and keep the rental property for a few more years. Eventually when he sells down the road he has to pay capital gains tax, realtor commissions, and mortgage fees. Can he deduct a percentage of these or any other costs from the equalization payment to the ex-wife? A family lawyer has said yes but only if the property needs to be sold in the near future in order to pay her out. But this seems unfair because eventually the man will HAVE to pay these costs when he sells so why should he not be able to deduct them now? Otherwise isn’t the ex-wife getting a free ride? Thanks to any advisors who can give their opinion on this.

Thursday, Nov 23, 2017 at 10:54 pm Reply

WantToKnowMore

How do capital gains apply in the following divorce scenario: Both spouses are listed on an unregistered investment loan along with an attached dividend paying mutual fund. It is agreed that one spouse assumes the loan/fund by creating a new account with the brokerage for only one spouse. The fund, at the time of divorce, had increased in value by 40%, and the settlement to the spouse leaving the investment was half of the increased value. Due to the nature of the fund, the ACB was calculated to be 90% of the initial investment amount. For simplicity, assuming an initial investment of $10,000, the market value of the fund at the time of the divorce settlement was $14,000, and the ACB was calcluated to be $9,000. The spouse leaving the investment was given 50%, in cash, of the $5,000 gain. Would that settlement payment ($2,500) trigger capital gains for the parting spouse? Additionally, how would the divorce settlement affect the capital gains when the remaining spouse sells the investment at a future date (assuming the investment continues to grow and the ACB continues to decrease)?

Monday, Nov 14, 2016 at 7:39 am Reply

MELISSA.SHIN.1

Hi there,

Please see this response from the author, Frank Di Pietro, which does not constitute advice:

Thanks for your question. For tax purposes, the tax implications on transferring non-registered investments that have appreciated in value between spouses as part of a settlement will depend on whether the couple is considered separated or divorced. I discuss the difference in tax implications in this article: http://www.advisor.ca/tax/tax-news/tax-traps-for-divorcing-clients-104726

Generally speaking, assets transferred between spouses occurs at the adjusted cost base and therefore there is generally no tax implications to either party when assets are transferred at cost. Also, the general rule of thumb is that once a couple is split, the attribution rules will not apply, meaning that any income or capital gains earned on the investment cannot be attributed to a former spouse. However, in the case of non-registered investments that have gone up in value, the attribution rules may apply on capital gains if the couple has separated and are not living together, but are not yet divorced. To avoid this situation, the couple needs to file an election which is further discussed in the article attached above. Once the couple are divorced, attribution is no longer a concern.
 
With respect to your question regarding the actual tax implications at the time of transfer, as I mentioned, the transfers generally occur at the adjusted cost base. However, if they choose, they may also choose to transfer the assets at their current fair market value, which would trigger the capital gain at the time of transfer. A separate election is required to accomplish this which should be done with the help of a qualified tax professional. Either way, whether the capital gain is triggered or not, the actual payments / settlements made to either party as part of a division of property is generally not considered taxable to either party. The couple should seek legal advice as to how the calculation of the settlement payments is established. In some cases, it may make sense to include the impact of taxes as part of the settlement. For example, the former spouse giving up his or her share of the investment could receive a payment / settlement of their share of the investment, on an after-tax basis to reflect the fact that the spouse retaining the investment will be responsible for the capital gains generated during the time they owned the asset together, if for example, the assets are transferred at cost and no taxes are triggered at the time of settlement.
– Frank Di Pietro

Thursday, Nov 17, 2016 at 11:19 am

Add a comment

Have your say on this topic! Comments are moderated and may be edited or removed by
site admin as per our Comment Policy. Thanks!