Capital Gains Tax (CGT) rules for divorcing couples set to change
When couples divorce, they do not immediately think of tax as a point that needs to be considered as part of the process.
To an extent, they are right. In most cases, transfers between spouses are exempt from inheritance tax so most divorces are structured so that the division of assets is agreed before the marriage (or civil partnership) is finally brought to an end. However, there is not such a blanket exemption for capital gains tax, which can add to the complexity (and expense) of agreeing a divorce settlement and even throw up an unwelcome surprise years down the line. Fortunately, the draft Finance Bill 2022/23 seeks to reduce the Capital Gains Tax ‘CGT’ burden at an already difficult time for divorcing couples. If the bill is passed in its current form, the change will come into force on 6 April 2023.
The current CGT rules for divorcing couples
The current general CGT rule is that a transfer by one spouse to another is deemed to be on a ‘no gain, no loss’ basis. So, if a husband bought a holiday home in his own name for £300,000 and gave it to his wife at a time it cost £350,000, he would be deemed to have disposed of it for £300k and she would have been deemed to have acquired it for the same amount. In other words, there is no capital gains tax. The trap is that the general rule only applies while the spouses are ‘living together’, i.e. before they are separated. After they have separated, the general rule only continues to apply until the end of the tax year of separation. If the general rule does not apply then the transfer will be deemed to be at market value. So, in our example, if the husband was transferring the holiday home as part of a divorce after the end of the tax year in which separation occurred, then he would be deemed to have made a gain of £50,000 and have to pay CGT on the gain (18% or 28% depending on whether the husband is a basic rate earner or not). Even though the wife has not in fact paid market value (or anything) for the property and so the husband does not have any sale proceeds from which to pay. Inevitably the husband is not happy that he is giving up his property and less happy that he is having to pay capital gains tax to do so. It also means there are less resources to be divided between the couple.
From a CGT perspective, it is therefore best if the transfers take place in the tax year of separation. Unfortunately, many divorces, especially in high value cases, can take more than a year to resolve and, if the couple separates on 31 March they have very little time to get their affairs in order before the end of the tax year on 5 April (in which case they might consider giving things another go for another week or so). The timing is even more of a challenge in cases where it is not just a holiday home in question but, for example, a portfolio of investment properties. The reality is that if a couple wants to separate, they are rarely going to have the CGT consequences in mind and, even if they separate early in the tax year, the divorce may very well not be complete before the CGT transfer window closes. Capital gains tax is then relevant when considering the division of assets.
A second issue can arise further down the line. In some cases the husband and wife own the house jointly but it is agreed that the primary carer should remain in the home until a certain trigger point, for example the children finishing their education. The divorce order states that the home should then be sold. There are no transfers at the time of the order, so capital gains tax is not a concern at that point. Say the divorce takes place when the youngest child is 15, when the husband moves out of the property. The youngest child finishes education at 21 and the property is then sold. If the husband and wife lived in the property from the point of acquisition, the wife should be able to claim principal private residence relief on the sale of the property. She therefore has no tax bill. By contrast, the husband can only claim relief for the period that he lived in the property and so may be landed with a capital gains tax bill for the gain on the property for the period between him moving out and the eventual sale (in addition to having to pay for a property valuation for the point he moved out).
The draft Finance Bill – extending the window of ‘no gain, no loss’ transfers
The draft Finance Bill goes some way to removing these issues. It extends the window of ‘no gain, no loss’ transfers to three years after the end of the tax year of separation. Where there is a formal divorce settlement, the ‘no gain, no loss’ treatment also applies, even if the transfer is made more than three years after the tax year of separation. That gives considerably more breathing room for divorcing couples to agree a comprehensive division of assets before risking a CGT charge. However, the bill does not remove capital gains tax as a consideration on divorce. It will still be a consideration in the division of assets. For example, if the wife receives the holiday home two years after she and her husband separate and it is then worth £350k, she will take it at her husband’s acquisition cost (say, following the above example, £300k). The wife will inherit the husband’s gain and (assuming the property does not decrease in value) she will have to pay tax on that gain if she sells it. This latent CGT will therefore still be relevant when considering the net effect of a settlement (even if it does not represent an immediate call on the wife’s resources).
The bill also extends the availability of principal private residence relief to cover the husband’s position given in the second example above, i.e. the husband will not lose principal private residence relief where a property he has retained an interest in (but which his ex-wife occupies) is sold to a third party, even though the husband has not lived in it since separation. Again, this goes some way to recognising the tax issue. However, it does not mean capital gains tax is irrelevant. The husband will need to decide whether to keep the former matrimonial home as his principal residence (and maintain relief on it) or decide whether to elect for his new residence to instead be his principal residence. That decision will be guided by a number of factors and so the amendments in the draft bill do not remove the need to take appropriate tax advice on a divorce.