The emotional grief associated with a separation or divorce is often so great that rarely any time or energy is spent on basic tax planning to ensure that when assets are ultimately separated any future tax pain is minimized.
Under the Income Tax Act, property can be transferred to a former spouse or common-law partner at its adjusted cost base (ACB) or tax cost in order to satisfy a property settlement arising from the breakdown of a marriage or relationship.
In the case of separation, the attribution rules that normally attribute any income or gains back to the transferor spouse don't apply for income such as interest or dividends, but would apply to future capital gains. However, the separating spouses or partners can make a joint election to avoid this future attribution.
Once a divorce is finalized, neither future income nor gains will attribute back to the transferor spouse.
Elliot Birnboim, a family and civil litigator with Toronto law firm Chitiz Pathak LLP, counsels high net-worth clients in divorce law and marriage/ cohabitation agreements. He says that tax considerations can form a significant component in establishing a fair asset split between separating or divorcing spouses.
"Your lawyer is negligent if they're not considering the tax implications of any equalization payment, whether in the context of the valuation of assets or the method of payment," Mr. Birnboim says.
Take the common scenario in which a divorcing couple jointly owns both a house and a cottage. As part of the divorce settlement, she keeps the matrimonial home (the couple's "principal residence") in the city and he keeps the cottage, which would subsequently become his principal residence.
Since both properties were owned jointly, he is essentially transferring his 50% interest in their home to his wife, while she is transferring her 50% interest in the cottage to him.
As discussed above, the transfer by the couple of their respective interests in both the house and cottage can be done on a tax-deferred basis. Furthermore, any gains or losses that may be realized on a subsequent sale of either the house or cottage won't be attributed back to the transferors as long as they make the joint election.
So, what happens when either the property or the home is ultimately sold?
The wife could claim the principal residence exemption on the sale of the home and thus pay no tax. When he sells the cottage, however, he may face a tax liability since only one property can be designated as a principal residence by a couple for a particular year.
Since the home was designated by the couple as their principal residence for the years prior to their separation, the principal residence exemption on the cottage would only be available to him for those years subsequent to their separation, assuming he doesn't buy another home, further complicating matters.
Thus, any tax accruing and ultimately owing by him on the cottage up to the date of separation needs to be taken into account to properly value this asset for purposes of any spousal equalization payment.
Clearly, both professional legal and tax advice should be sought in these situations.