Divorce and Real Estate - Part 2
Divorce, Part II: Tax Considerations
In our last post, Divorce Part I, we looked at the different choices spouses have in deciding what to do with shared property, like the home you live in. Generally, people will decide to do one of three things with their matrimonial home; sell it and split the proceeds evenly, have one spouse buy out the home from the other spouse and keep it to live in, or have one spouse remain living in the home until the youngest child turns 18 and/or moves out. Beyond that, there are also tax considerations that may come into play when deciding what to do about your home, so in this post we are going to look at a few Canadian tax basics. Please keep in mind that tax rules around property and divorce can be very complex, so take this post as a very brief overview just to get you started before contacting your accountant or financial planner for advice that is specific to your circumstances.
If you are unfamiliar with the term ‘capital gains’, make sure you start your research here. The CRA explains a capital gain this way: “You have a capital gain when you sell, or are considered to have sold, a capital property for more than the total of its adjusted cost base and the outlays and expenses incurred to sell the property.” In other words, a capital gain is the money you earn when your asset increases in value above what you paid for it, i.e. the difference between what you paid for it and what it’s worth now. A capital loss means the same, but in the case where an asset has decreased in value since you purchased it. Most of the time, property will earn you a capital gain, especially if you have kept it for a long period of time because property values generally increase over time, even when dips in the real estate market are taken into account.
Election to not report the capital gain or loss
The Canadian tax system, and the law, is designed to keep things as fair as possible, so it assumes that you shouldn’t have to pay taxes on the increased value of an asset if you are no longer in control of that asset. Normally this means that once you have transferred a property to your spouse as part of the separation process, you will no longer need to report any capital gains on it, as long as you have submitted an election to not report the capital gain (or loss). Timing is everything with this. You want to make sure you have submitted your election to not report the capital gain or loss before a separation/divorce settlement is finalized. Rebecca Hett explains this further in her article for Advisor’s Edge, Tax implications of divorce, Part 2: Settling different types of property:
“Where a married couple is separated but not yet divorced, the parties must file a joint election in their tax returns to ensure attribution won’t apply to capital gains of any subsequent sale of transferred property. If the election is not made, then the capital gain arising from a subsequent sale of the transfer of property, while the individuals are separated and not yet divorced, will attribute back to the transferor.”
Considerations when splitting family assets
If there are several financial assets to divide as part of your divorce settlement, it’s likely in your best interest to try and keep the house. This is because the principal residence exemption means you’ll pay the least taxes on it when you sell after the divorce, in comparison to other assets like RRSPs, or non-registered investments. Chartered Accountant Allan Madan gives an excellent explanation of why this is, in his article, Tax Implications Of Divorce And Separation In Canada. For example, one of his suggestions is that if you own more than one matrimonial property together, split the two properties between each of you, so that you can both claim the principal residence exemption when either of you is ready to sell post-divorce.
Clients can have more than one matrimonial home, and this is based on properties that are purchased during the relationship, rather than before the relationship. For example, a couple might have their primary residence, a secondary residence elsewhere in the city or out of town (eg. a home bought for the kids to live in while going to university), or vacation properties. Matrimonial properties like these must be divided equally, whether both names are on the title or not. This is different from property owned by one spouse before the start of the relationship, because in that case it might only be the increased value that occurred during the relationship that must be split. For example if one spouse owned a home worth $250,000 at the time of getting married, but now the fair market value (FMV) of the home is $350,000, that means $100,000 is on the table to be divided between the spouses if the home goes up for sale.
Properties that you obtained as a gift or inheritance before the relationship, or that were awarded to you for damages are considered exempt properties in the divorce settlement process. This means that the original value of the property would be exempt, but if it went up in value during the relationship you might have to split the added value with your spouse, depending on how the court calculates that financial increase. That calculation will be different depending on the province, since some provinces will calculate the division starting on your date of separation, while in other provinces (like Alberta) it will be calculated from the date of settlement or trial. In her article, Tax implications of divorce, Part 1: Dividing assets and navigating tax credits, Rebecca Hett explains, “Proving exemptions means proving property value on both the date acquired and the division date, and proving it was kept separate from family property.”
Equalization is the process where the spouse with higher net worth pays out a calculated amount to the other spouse so that they leave the relationship in a similar financial position. Typically, equalization payments for property do not incur tax consequences (eg. by using the election to not report a capital gain, as explained earlier in this post). Also, as long as the settlement/divorce isn’t finalized yet, a spouse can transfer assets such as property, by way of a ‘spousal rollover’ at tax cost. Keep in mind that for the duration of the relationship (i.e. until the settlement is finalized), spousal attribution still rests with the gifting spouse for tax purposes. In other words, if the property makes any money while you’re still married, the spouse who originally owned that property will still be the one on the hook to pay taxes on it.
At arm’s length: Peter Routly explains in his article for BDO Canada, Tax Implications of Separation or Divorce For A Business Owner-Manager: “A marriage is ended only through legal divorce, regardless of the length or distance of your separation. This means that even if you have been separated from your spouse for years and live on opposite sides of the country you cannot be considered to be at ‘arm’s length’ for tax purposes—until a divorce is finalized. (That said, there may be circumstances under which you do not deal at arm’s length, even after divorce.)” So, this will affect the way your taxes will be calculated on properties and capital gains or losses at least until the divorce is finalized. ‘’At arm’s length’ may come up as a concept when determining spousal attribution rules, as it pertains to selling your home or homes after the settlement is done. This circles back to what was discussed earlier in this post about principal residence exemption and matrimonial homes.
The tax implications of distributing property as part of your divorce settlement are very complex. Best practice would be to speak with your accountant and your lawyer first, as well as your real estate agent about how best to proceed. Hopefully the tips offered here will help you to feel better prepared for those conversations.
When you’re ready to put your home up for sale, please reach out to our team at [email protected], who will be happy to help!