If you’re going through a divorce or separation, you need to think about taxes when dividing property.
The impact of income taxes shapes the size and type of assets that are transferred between spouses as part of the settlement process.
For income tax purposes, transfer of assets between spouses and common law partners, 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. This is often referred to as a rollover.
This is often referred to as a rollover.
The person receiving the asset is generally taxed when he or she ultimately sells or disposes of it (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 applies automatically unless the parties decide to transfer the asset at its fair market value (which triggers a capital gain upon transfer).
This approach would benefit the transferring party if he or she has unused capital losses available to offset those capital gains.
Tom plans to transfer a $100,000 non-registered mutual fund portfolio to Katie after their marriage breaks down. Tom bought 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 him. 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 × 50% inclusion rate × 45% tax rate).
But, if Tom elects to not have the automatic rollover provisions apply, he can transfer the portfolio at its current fair market value ($100,000) and trigger the $50,000 capital gain.
Then, he can apply his unused capital losses against this gain, and the result again would be no taxation.
Plus, Katie will inherit a portfolio with an ACB of $100,000 (instead of $50,000). When she sells it in the future for $120,000, her tax liability will be reduced to $4,500 ($120,000 – $100,000 × 50% inclusion rate × 45% tax rate).
RRSP and RRIF transfers
If some or all of the money in an RRSP or RRIF are transferred between spouses or common-law partners due to separation or divorce, the transfer can take place on a tax-deferred basis on two conditions:
- the money being transferred remains in an 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 that RRSP or RRIF, the full amount is taxable in that person’s hands at their marginal tax rate in the year of withdrawal.
So, in some cases it makes sense to transfer some or all of an RRSP or RRIF as part of equalization between spouses.
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 time when his or her taxable income is lower.
Updated June 2016.
Frank DiPietro, CFA, CFP, is assistant vice-president, Tax and Estate Planning, at Mackenzie Financial.