Divorce can be difficult enough without paying unnecessary tax because you are unaware of the rules in this area. Graham Doubtfire, Tax Partner at Scrutton Bland, explains some of the financial legislation which may affect your settlement.
Capital gains tax (CGT)
When a couple is married and living together, any transfer of assets between them will take place at “no gain / no loss” (NG/NL) meaning that no CGT will be payable. However this tax benefit of marriage ceases at the end of the tax year following permanent separation and not on the legal divorce (Decree Absolute). The tax year runs from 6 April to the following 5 April therefore the closer a couple separates to 5 April, the less time they will have to transfer any assets if they wish to make use of the NG/NL rule.
Following the tax year of permanent separation, but before the Decree Absolute, spouses and civil partners are still classed as connected persons for CGT purposes. This means any transfer of assets will be deemed to have taken place at market value, regardless of whether any actual proceeds were received. Therefore CGT will be due on the market value less the cost of the asset. If the asset has appreciated significantly since acquisition, there could be a large amount of CGT due.
Conversely, any assets transferred which are sitting at a capital loss will result in a “clogged loss”. Generally capital losses are set off against capital gains of the same year or carried forward to set off against subsequent gains. Where a loss arises on a disposal to a connected person, the loss can only be set off against gains from the same connected person. If a loss arising as part of the divorce settlement cannot be offset by other gains, the potential to use this loss in the future is severely restricted.
Where a transfer of assets does result in a gain, it will be liable to CGT at 10% for any gain falling within the basic rate band (18% for residential properties) and 20% for gains falling within the higher rate band (28% for residential properties).
Certain assets may qualify for the Entrepreneurs’ Relief rate of CGT of 10%, however qualifying conditions have to be met.
Private Residence Relief (PRR):
One of the largest and most important assets is often the matrimonial home. This may end up being sold to a third party, or one party to the marriage transferring all or part of their share to the other as part of the settlement.
Generally, if an individual has lived in the matrimonial home for the entire period of their ownership then the whole of their gain on the property will be covered by PRR. However, if there have been periods where the property was not lived in or another property had been elected to be the main residence for CGT purposes, the relief could be restricted.
Provided a property has previously qualified for the relief, the last 18 months of ownership will always be classed as deemed occupation which means PRR will be available for this period. Potential CGT charges therefore arise where one party moves out of the matrimonial home and the time to agree a settlement and effect transfers exceeds 18 months.
However there are special rules on divorce which allow the relief to be extended if all of the following conditions are met:
- One spouse or civil partner stops living in the family home because they have separated
- The partner that moved out has not formally elected with HMRC for another house to be their main residence
- The partner that moved out later transfers their interest in the family home to their ex
- The other partner keeps living in the family home as their main residence
- The transfer is made as part of the divorce settlement
This special rule does therefore not apply if the home is sold to a third party.
Care also needs to be taken by the spouse giving up the ownership of the former family home where they have acquired a new residence, because generally only one property at any one time can qualify as the PRR.
Income tax is not charged on the transfers under a divorce settlement. If however an income generating asset is allocated as part of the settlement, the transferee will be subject to income tax on any income from the date of transfer.
Transfer of assets remain exempt from inheritance tax (IHT) until the date of Decree Absolute (although the exemption is limited to £325,000 if the transfer is to a non-domiciled spouse). Transfers after Decree Absolute are potentially exempt transfers (PET) and will be exempt from IHT if the donor survives seven years.
Property transferred between spouses under a court order is not subject to Stamp Duty Land Tax, even if the transferee takes on a mortgage.
A divorce is often complex. It will be important to review all matrimonial assets and seek advice with regards to planning to ensure settlements are structured in the most efficient way and that no one is unintentionally left with an unwelcome tax charge.
It is often a requirement of a Court Order that an independent Expert Witness Report is obtained to document the CGT implications of any divorce settlement. Graham Doubtfire has assisted a number of divorcing parties with Expert Witness Reports.