Lee Sharpe looks at some of the tax implications of divorce and joint investment property assets.
In this article, I shall look at some of the income tax and capital gains tax (CGT) implications of divorce, on investment property assets held jointly between spouses/civil partners. There are, of course, myriad legal aspects to divorce and property ownership, and who is entitled to what. Such is the domain of divorce lawyers, rather than mere tax advisers.
Basic rules for income tax and CGT
- Income tax and CGT primarily follow beneficial ownership – the equitable interest that a party holds in the property – rather than simple legal ownership (except when they don’t; see income tax below), and
- The special tax treatments availed of spouses and civil partners usually start to unravel when the couple no longer live together – which can, of course, predate actual divorce by some margin (this is not always the case with all taxes: for instance, the transferable nil rate band for inheritance tax purposes (at IHTA 1984, s 8A-C) requires only that there be a legal marriage and not that the couple be living together when the first spouse dies – understandable, where age and infirmity may all too often prevent cohabitation).
Income tax
Having said that income tax usually follows beneficial ownership, many readers will be well aware that income tax law usually assumes a 50:50 split of income from assets held jointly between co-habiting spouses/civil partners, regardless of the underlying actual beneficial ownership, unless that beneficial ownership is formally notified to HMRC; likewise, spouses trading in partnership may split trading profits broadly as they like, regardless of the respective interests in partnership assets (see ITA 2007, s 836, et seq.).
However, the default presumption of an equal share in joint assets breaks down once the couple split and are no longer living together as a couple; once that happens, the income apportionment will generally follow the equitable interest therein.
Example: Separation during the tax year
Zack and Gertrude are married and jointly own an investment property – Zack’s former bachelor pad. For several years, the property has been owned 90% Zack and 10% Gertrude, but as they have not formally notified HMRC of their different interests, ITA 2007, s 836 means that the rental income has traditionally been split equally between them. On 6 July 2018, Zack and Gertrude split, irreconcilably.
For the first quarter of 2018/19, their rental income will be divided equally. For the last three quarters of the tax year, in the absence of any binding agreement to the contrary, it should normally be split according to their actual respective interests in the property – 90:10 in Zack’s favour.
Capital gains tax
It is common knowledge that spouses and civil partners may transfer assets between themselves, normally without triggering a CGT charge, thanks to TCGA 1992, s 58. This does, however, depend on their living together as a couple at the time of the transfer, and we should consider what ‘living together’ actually means.
Living together and connection
The fact that a couple may be apart for long periods of time – say for work or medical reasons – does not prevent them from being treated as living together for tax purposes. Spouses and civil partners will generally be assumed to be living together even if they are not physically cohabiting, unless:
- separated by court order;
- separated by formal deed of separation; or
- they are as a matter of fact separated in circumstances which are likely to be permanent.
The statutory basis for this is found in ITA 2007, s 1011, which translates across to CGT legislation by reason of TCGA 1992, s 288.
While this seems practically expedient, it can have some potentially adverse consequences, typically for CGT treatment on divorce. This is because married couples and civil partners will remain ‘connected parties’ for CGT purposes until the marriage or civil partnership is formally dissolved, under a decree absolute or final dissolution order, respectively. This can be quite some time after permanent separation – several years, in fact (they could potentially be connected for reasons other than marriage, but this is ignored here for simplicity).
Timing is critical
The usual CGT treatment for transfers of assets between spouses and civil partners persists throughout any tax year in which they are living together, as above, at any point in the tax year. Therefore, if Gertrude were to return her 10% stake in Zack’s former home at any time in 2018/19, the actual consideration given (if any) would be ignored, and the transfer would give rise to neither a gain nor a loss under CGT rules, i.e. it would be CGT-free.
Once that tax year of permanent separation has expired, however, but while the couple remain ‘connected’ for tax purposes, any actual consideration would still be ignored automatically, as before, except this time it would be replaced by the actual market value of the property transferred, with CGT chargeable accordingly.
So, if Gertrude were to return her share of the investment property after 5 April 2019 but before the decree absolute, she would be charged to CGT as if she had sold her 10% stake in the property back to Zack at market value, even if she gave it back to him for nothing.
What is the disposal date?
This can become a quite complex issue since assets are often transferred between couples without the paperwork normally seen in commercial transactions, and because transfers relating to divorce proceedings are often affected under court order.
This can affect the date on which the transfer is deemed to take place, broadly as follows:
- asset transferred under a court order before decree absolute (or civil partnership dissolution order): the effective date of disposal for CGT purposes is the date of the court order;
- asset transferred after decree absolute but pursuant to a court order made before decree absolute: disposal date for CGT purposes is the date of the decree absolute or dissolution order; or
- asset transferred after decree absolute, pursuant to a court order also made after decree absolute: CGT disposal date is the date of the order.
Market value rule post-divorce
Having warned that, for CGT purposes, any actual proceeds are ignored and replaced automatically with the property’s market value if the inter-spouse transfer is affected after the tax year of separation but before the date of the decree absolute/final dissolution order, one might assume it is safer to transfer property afterwards once the dust has settled. It is often overlooked that the market value rule can supersede actual proceeds at almost any time, between broadly any parties, where the donor intends to transfer without full consideration (i.e. where there is an element of gift to the transfer). Similarly, disposals undertaken in pursuance of a court order are deemed not to be by way of a bargain at arm’s length, so the market value may again be interposed.
Conclusion
Where interests in jointly-held land or property are exchanged, (such as when a divorcing couple want to extract parts of an investment portfolio that each spouse then wants to own outright), a measure of relief can potentially be available (under TCGA 1992, s 248A), effectively to postpone gains until those properties are actually sold. But generally speaking, it is very easy to fall foul of the many rules surrounding joint assets and divorce – particularly when transferring interests in assets as the divorce proceeds.
Practical Tip:
Careful advice, planning, and implementation are required in order to ensure that tax liabilities are not needlessly triggered.
