How real estate is taxed during a separation or divorce

How an asset transfer between spouses is taxed

First off, a transfer of assets between spouses is by default done on a tax-deferred basis at the original purchase price. So, whether the properties are held individually or jointly, either person can transfer their share of the ownership of a house and/or cottage to the other spouse without triggering an immediate tax implication.

They can elect for the transfer to occur at any value between the adjusted cost base and the fair market value. We will come back to this point.

Watch for spousal attribution

When married or common-law couples transfer assets between each other, there’s always the risk of spousal attribution. This may apply if one spouse owns an asset or contributes primarily or exclusively to its purchase and transfers the asset to the other spouse. If the receiving spouse then earns income from it or sells it for a profit, there may be attribution of the income back to the transferring spouse. The income, or capital gain, would be taxable to the transferor.

Spousal attribution does not apply after separation or divorce. So, you can transfer assets and not have to worry about future income being allocated to you down the road. However, there could be lingering tax implications for one or both individuals.

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How the principal residence exemption applies in separation or divorce

A couple can only have one principal residence in any given tax year. Your principal residence is not necessarily the place where you primarily live. You can claim your cottage, for example, as your principal residence.

When a separation is amicable, the couple should determine together which property, when treated as the principal residence, would result in the least amount of tax. Specifically, they should consider the annual capital appreciation of each property, calculated as the total appreciation divided by the years of ownership.

Let’s say ex-spouses named Jo and Chris owned a cottage for a short period of time, and it appreciated significantly. They might agree to treat the cottage as their principal residence for the years they owned it. Jo could transfer full ownership to Chris, and they could jointly elect to have the transfer take place at the fair market value. Jo could claim the principal residence exemption to avoid tax in the year of transfer. Chris may be able to claim the cottage as their principal residence for all years of ownership given it will be the only property they own after the separation, and it will qualify for the principal residence exemption in subsequent years as well.

That means Jo will have to pay tax for some years of house ownership, because the cottage was claimed as the couple’s principal residence during the years it was owned. Jo may have some years of ownership before the cottage purchase, as well as more years after the separation, where the house can be their principal residence. But they will have to pay some capital gains tax eventually when they sell the house. It will be based on the total appreciation when they sell it, or die, and the pro-rated years where the couple claimed the cottage relative to the total years of ownership.

Chris may then agree that Jo should get more cash or other assets to account for this future tax liability. If they do not address this, the first person to sell a property might claim the principal residence exemption and expose the other to tax. Ideally, they would figure out what is mutually beneficial to them.

Other tax considerations

When transferring property from one spouse to another, Peter, there may be other implications, like land transfer tax. In the province of Ontario, for example, a transfer can be made if it’s pursuant to a written agreement, like a separation agreement, without attracting land transfer tax. So, it’s important to consider the implications related to the province, territory or city in which the properties are located.

Have the assets been equitably split?

As the separation is finalized, each spouse should work with their accountants and lawyers to determine an equitable division of assets that considers the tax implications. For example, $1,000 in registered retirement savings plans (RRSPs) is worth less than $1,000 in tax-free savings accounts (TFSAs), because there is deferred tax for the RRSP accounts. The same logic applies for the house and cottage. Each individual should calculate the tax implications of the property received to be sure their equalization is in fact equal.

Read more about taxes on real estate:

• How it works: Capital gains tax on the sale of a property
• The tax implications of buying a second home in Canada
• The tax implications for Canadians selling foreign real estate
• What are the taxes on transferring real estate to your kids?

About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.

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