When a relationship ends, married or common-law partners often face financial and tax consequences of the marriage breakdown. One of the most difficult issues to deal with (aside from custody and support questions) is how assets should be divided, preferably in a manner satisfactory to each party.
This article deals with the tax implications of a division of assets under these circumstances. Other topics, such as tax issues related to custody and support arrangements, tax implications of a transfer of real property (including the family home) and shares of a private family corporation, will be discussed in separate articles.
Generally, family property division falls within a province’s family law. Provincial family law legislation begins from a presumption of equal distribution, but permits spouses to contract out of the scheme in certain circumstances by using a co-habitation agreement (commonly known as a prenup) or a separation agreement. How spouses divide their property is often influenced by the tax consequences. Under the Family Law Act in Ontario, a domestic contract – which includes a prenup and a separation agreement – is valid if it is in writing, signed and witnessed. It is up to the individuals to determine tax consequences by consulting independent legal counsel and reviewing the financial disclosure provided.
Property owned by one spouse (spouse A) and transferred to the other spouse (spouse B) occurs automatically at cost if:
- Both spouses are Canadian residents when the property is transferred
- The spouses have not yet divorced
- If common-law partners they have not lived apart due to a breakdown in the relationship for at least 90 days, or
- If the transfer is to a former spouse, the transfer is pursuant to a settlement of rights arising from the marriage or relationship
The transfer will occur at cost even if spouse B pays fair market value consideration to spouse A. It is highly unlikely, therefore, that spouse B will not insist on the election discussed below under such circumstances. A transfer at cost will not result in any immediate tax consequences to spouse A. Spouse B will have the same cost base as spouse A as a result, and essentially, spouse A has transferred any future gain to spouse B (subject to comments below regarding the application of the attribution rules).
The partners may elect to transfer at fair market value under subsection 73(1) of the Income Tax Act (ITA) instead of cost. The election must be made in the return for the year of the transfer. As there is no specific form required, the election is often a paper document. Even if filed late, the election can still be made in the late-filed return.
Considerations as to whether to transfer the property at cost or fair market value will depend on several factors, including:
- Amount of capital gain triggered if the election is made
- Whether spouse B will pay any consideration for the property
- Spouse B’s intention with respect to the property (sell or hold), and
- Timing of the sale
The principal consideration will be how the attribution rules affect the taxation of post-separation income and gains realized from the property.
The attribution rules apply normally when one spouse transfers property to another spouse at less than fair market value. Future income and gains would be taxed in the hands of the transferor spouse unless the spouses make a 73(1) election and fair market value consideration is paid. Special rules apply when the transfer of property happens due to separation or divorce.
There is no attribution of future income back to spouse A for payment relating to the period after separation. This rule applies automatically.
However, future gains realized by spouse B will still be attributed back to spouse A unless the spouses are divorced by that time. Therefore, married spouses should ensure they file a joint election to be excluded from the attribution rules under 74.5 of the ITA. This joint election may be filed with the transferor’s return of income for the year the property is sold or an earlier year.
If spouse B has no plans to dispose of the property, or if spouse A has sufficient losses carried forward to offset any capital gain realized on a transfer of property, a 73(1) election may not be necessary. However, a 74.5(3) election should still be made to ensure no attribution of future gains.
Failure to file one or both elections may result in unintended results for the spouses.
Each spouse should consider the tax implications of a property division with the assistance of tax and legal professionals.
Written by Segal GCSE Tax Team. This document was written for our quarterly bulletin, Canadian Overview, published by Canadian member-firms of Moore North America.