Divorce can cause several future tax headaches, including the potential loss of tax credits, CGT and IHT liability, but speedy treatment can help reduce the damage, writes the Chartered Institute of Taxation's Matthew Brown.
David has recently separated from Sam and will be divorcing her. David works full time but Sam only works part time. They have been married for 20 years and have two teenage children and a younger child, who will live with their mother.
They have a house with a mortgage, which is jointly owned, and some cash savings and shares, mostly in Sam’s name for tax reasons. David has moved out of the family home. He is currently living in rented accommodation, but he is thinking about buying a property with his new partner.
Sam wants to stay in the house with the children at least until they are adults, but David would prefer a clean break. However, the cash and other savings are not likely to be sufficient for Sam to buy out David’s interest in the house and it is unlikely Sam could get a mortgage on her own. David is paying child maintenance to Sam under an informal arrangement and he is continuing to pay the mortgage.
What advice can be given to David (and Sam) on the tax liabilities that might arise when couples divorce?
David has a number of problems that could have long-term effects on everyone concerned.
Take the effect of separation on tax credits. Up to separation, David and Sam were assessed as joint claimants. Their separation is a change of circumstance that should be notified to HM Revenue & Customs (HMRC) within one month of separation. Thereafter, Sam will be a single claimant. This is likely to make a material difference to her entitlement and, since increased entitlement will only be backdated one month, the earlier Sam notifies HMRC the better.
Next, capital gains tax (CGT). For the tax year of separation, transfers of assets between spouses are exempt as they take place on a no gain/no loss basis. Until the decree absolute (the certificate dissolving a marriage) is made, transfers are at market value, meaning a CGT liability may arise. The inheritance tax (IHT) for transfers between spouses continues until they are actually divorced.
If Sam wants to acquire David’s interest in the family home, but will be transferring all the other assets to David, it may be desirable to transfer the stocks and shares sooner rather than later.
Then we have the family home: if the property is retained in the long term and kept in both names, David may start to accrue a CGT liability when it is sold. A husband and wife can only have one CGT exempt main residence between them. There is just the one house and they were both living in it, so it is currently CGT exempt. However, now that David isn’t living there, it is no longer his main residence and his share is potentially no longer exempt.
If the property is sold or transferred to Sam’s sole name within three years of David moving out, full CGT exemption is maintained. Thereafter, David could start to accrue a CGT liability.
To stay exempt David can transfer the house to Sam under a financial settlement. The transfer may still be CGT exempt if David has not elected for any other property to be his main residence.
If the house is retained until the children are grown up (more than three years away), the CGT-exempt status on the family home may be safeguarded by a court order known as a Mesher order. This directs that the sale of the matrimonial home is to be postponed until a specified time.
It usually creates a settlement for tax purposes. So long as one party remains in the property, the CGT exemption can usually be claimed in full on its eventual disposal. However, a side effect of the Mesher order is IHT. The creation of the settlement is likely to be treatable through IHT exemption (eg, as being a transfer for family maintenance), but exit and 10-year charges could arise.
Finally, maintenance payments: there is no tax relief for David for making maintenance payments, but these are tax free for Sam.
Matthew Brown is technical officer at the Chartered Institute of Taxation.