How to deal with divorce-related taxes ?
In Canada, where more than 40 per cent of all marriages will end in a split, most divorces are considered “no fault.”~National Post
If you think that after 25 years of marriage, the likelihood of a divorce plummets, think again, due to increased life span and other variables ,an increasing number of people married for more than 25 years still seek a divorce. Divorce presents financial challenges at any age, but for those over 55 (“Grey hair divorce”), it gets further complicated by the demands of impending retirement and any plans that had been made leading up to retirement.
Recently separated couples are not just having to coordinate parenting and who gets the dog, but they also have to deal with various tax implications.
Spousal relationships, cohabitation and marriage, needs to be examined in light of their financial and legal implications and not just within the poetic models we idealise.
The first line of defence in any separation scenario where the downside risk is a 50% reduction in your wealth is to manage that risk.
Divorce commonly results in settlement of marital property rights, including but not limited to:
• Assets including real property and other assets such as investments
• Personal and company-sponsored pension plans.
Common misunderstandings get compounded by unequal net worth, children, stepchildren, and estate planning considerations. Nonetheless, various tax saving opportunities help in availing valuable tax credits and refunds at a time when you are likely moving from two incomes supporting one household to two incomes supporting two households.
This article covers the critical undermentioned points which are just a tip of the iceberg covering broadest tax entanglements of marital matters, and although it refers to spouses and legally married couples, the reader should understand that the Income Tax Act handles common-law partners identically to married couples.
1) Understand when the Canada Revenue Agency (CRA) will consider a separation to be valid
A separation which is shorter than 90 days is not considered a separation for child and family benefits. For the child benefit, the CRA may recognise you as being separated, if you live in separate households. However, if you continue to share parenting and financial responsibilities in the same household, the CRA may not recognise your separation for child and family benefits and the GST/HST credit.
2) Inform CRA
The CRA exacts you to notify them by the end of the month following the month that your divorce, you can do so by
• Sending Marital Status Change form (http://www.cra-arc.gc.ca/E/pbg/tf/rc65/README.html)
• Calling 1-800-387-1193
• Going to My Account, your online CRA Account (http://www.cra.gc.ca/myaccount) or
• Going to either MyBenefitsCRA or MyCRA apps page on the CRA website
Once CRA reviews your request, if you qualify, it will send you a GST/HST credit notice advising you of the amount of your GST/HST credit.
“Divorce is one of the most financially traumatic things you can go through. Money spent on getting mad or getting even is money wasted” ~ Richard Wagner
3) Keep receipts and important information
Marriage is a private affair where your incomes may be combined, expenses distributed, and who gave what to who gets typically messy over time. Unfortunately, after separation, it’s vital that you be more business oriented as keeping records and receipts such as cancelled cheques proving payments, past T1 Tax returns is critical.
4) Prepare for Split of Family Assets
Paying your spouse their half of the assets is called an equalisation payment and an asset transfer. Typically cash for equalisation payments is not taxed during a divorce because it is considered after-tax money.
All assets acquired before your marriage or “gifted” for marriage need not be split as they’re considered assets are belonging only to the person that holds legal entitlement.
Assets which you acquired during the marriage (pension included) get split among spouses (50% each).
Business is almost always the most disputed asset in a divorce, with a lot of the numbers in a settlement derived from its value, so you will need business valuation from a CPA or CBV.
Your Assets such as a House or Investments, for example, will get valued at FMV (Fair Market Value) before being split at the time of separation. These will attract tax on the difference between the FMV and the cost you originally paid for them. However, for an asset transfer in divorce, there is a strategic financial option that allows you to use what’s called an automatic rollover provision under Subsection 73(1) of the Income Tax Act (ITA), that will delay any taxation on the transfer.
This section automatically applies to transfers of Marital Assets. The following types of transfers of property are tax-free:
• A transfer to a spouse
• A transfer to a former spouse arising as a result of the settlement of spousal rights
The transferee spouse takes over the transferor spouse’s position concerning the tax attributes of the property transferred. If the property transferred is a depreciable capital property on which capital cost allowance (CCA) has been claimed, the transferee spouse takes over both the capital cost and the un-depreciated capital cost (UCC) of the transferor spouse.
Please do not forget that the rollover doesn’t mean you will never pay tax on that asset; it only indicates that a transfer done as part of the separation agreement will get tax-deferred to the future.
You may elect out of the automatic transfer, whereby the proceeds of disposition to you and the cost to your spouse will equal the fair value of the property transferred. This election may be beneficial in the following situations where there is an accrued gain on the property transferred and:
• A capital gains exemption may be claimed on the transfer of qualified small business corporation shares (QSBCS).
• The transferor has a non-capital or net capital loss that they do not expect to be able to use in the foreseeable future.
• There is an accrued loss on the property transferred, as the superficial loss rules do not apply to deny the loss where there is a transfer due to a settlement of marital property.
No rollover provisions exist for the transfer of assets held as inventory, so the transfer of these assets happens at their fair value for income tax purposes. Also, assets held with the intention of resale at a profit are “inventory” held in an “adventure like trade”. For example, you cannot rollover land purchased with the intention of making profit from increase in the value with passage of time.
5) Pension Plans
The valuation of pension plans is based on many assumptions, such as rates of return, future earnings, and age of retirement. Based on the articles of the pension plan, it may be reasonable to do pension income splitting at the source, so each spouse receives pension benefits undeviatingly.
On the other hand, where there are sufficient family assets, you may decide to trade other assets rather than splitting the pension plan. For example, your spouse may get to keep the house while you retain the full pension.
If the pension plan so allows, it might be possible to transfer some or all of the value of the pension plan on a tax-deferred basis.
If you receive a pension at the time of separation or divorce, the non-member spouse to your pension plan may be entitled to receive part of the monthly pension.
6) Canada Pension Plan
You or your spouse may independently apply for a split in your CPP credits. If this happens, the credits built up by both of you during each year of marriage will get combined, and then split equally.
Alternatively, you may elect not to divide the pension, for example, if you and your spouse have made maximum contributions during the relationship.
7) Registered Retirement Savings Plans (RRSPs)
RRSPs continue to be the most significant tax savings opportunities available to individual Canadians, and they do not need valuation as their value is always equal to the account balance. RRSP or RRIF funds may be transferred to a spouse’s RRSP or RRIF on a tax-free basis if the following conditions are met:
• The former spouses are living apart.
• The payment is made according to either a decree, judgment or order of a competent tribunal or a written separation agreement.
• The transfer is made directly between plans.
It is essential that the funds not be withdrawn from your spouses RRSP and provided to you for RRSP contribution as your spouse will have to pay tax on the amount of the withdrawal. Moreover, you might not have sufficient deduction room to contribute the full amount to your RRSP. The relevant form for transfer is to be finished by both spouses and the administrators of the transferring and acquiring RRSP, RRIF, or SPP.
8) Canada Child Tax Benefit
The Canada Child Benefits which you receive as a tax-free monthly payment for your children is based on family income; including combined income of you and your spouse. It aims to help eligible families with the cost of raising kids under the age of 18.
The primary caregiver is entitled to collect the child tax benefit.
If you are separated or divorced, then just your income will be factored into the calculation for the Canada Child Benefit which you are entitled to as your spouse’s income is not counted for determining the child tax benefit.
Therefore, it’s possible that you might receive an increased amount of the Canada Child Benefit after divorce or separation.
If you have shared custody of your children, you may have to share child benefits with your ex as the CRA may divide the benefit 50/50 between you and your ex.
In the case of Perron v. the Queen, (2017 TCC 220), Ms Perron and Mr H, her ex-spouse, were divorced. However, they shared custody of the kids. Ms Parron wanted to claim the full amount of the Canada child tax benefits (CCTB), and the GST/HST credit in regards to her kids for the years 2013 through 2016. Even though their divorce order defined that she and her ex-spouse shared equal custody, it also said that she alone would be allowed to receive the CCTB for the kids (the order was silent on the GST/HST credit).
The taxman decided she was not qualified for the full benefits because she had joint custody. The taxman decided, instead, to pay her half the benefits. The judge remarked that the Income Tax Act is worded such that it doesn’t matter what any agreement between the spouses says when determining who should collect the CCTB. Since there was joint custody, the benefit is split between the parents.
9) Principal Residence
The value of the all the family asset including the principle residence must be determined for the division of property.If you and your spouse jointly own a couple of properties together such as a Family home and Cottage,you can designate one property to each of you (sale of the property not needed ) at the time of separation. The gain on the ultimate disposition of either the family home or the cottage will be sheltered (at least partially) by the principal residence exemption.
You can claim the principal residence exemption on one property for any given year, and the property must be ordinarily inhabited. Alternatively, you might decide to sell the house or the cottage, and claim the principal residence exemption on the transfer of a personal residence providing a higher cost base to your (transferee) spouse.
10) Certain Legal Fees Are Tax Deductible
If you have to pay legal charges to your lawyer to collect support payments, the CRA will allow you to deduct this fees. However, legal expenses paid to your lawyer to prepare a separation agreement or negotiating the division of family asset is generally not tax- deductible.
11) Eligible Dependent Tax Credit
Income Tax Act paragraph 118(1)(b) provides the eligible dependant credit which is available if you are single, divorced, separated, or widowed, are not claiming the spousal credit, and you supported a dependant:
• who is under 18
• living with the individual
• related by blood, marriage, or adoption
• a resident of Canada (except child)
• dependent on an individual for support
In case you have primary custody of your children, the credit may go to you. Whereas, if you have children through joint custody, then decide whether you or your spouse should claim this credit. Both you and your spouse cannot claim the credit.
The credit can be claimed for one qualifying child annually, and if you have more than one child, you may pick which one to declare for this credit. You may also decide to claim one child one year and the other the following year. Any income the child earns gets deducted from this credit dollar-for-dollar.
If you make child-support payments you may not be able to claim this credit. A recipient of child-support payments may claim the credit.
12 ) Child-care expenses
On separation, the higher-income earner / lower-income earner rules do not apply. Each of you will be permitted to deduct child-care expenses paid personally while the children are in your custody as long as the costs are incurred to help you earn business or employment income or allow you to attend school. In shared custody, each party can claim expenses incurred that otherwise meet the requirements, notwithstanding the amount claimed by the other spouse.
13) Spousal payments
Spousal support amounts paid for spousal support are deductible to the payer and taxable to the recipient if the following five tests are met:
• The payments are periodical
• The payments are an allowance for the maintenance of the recipient.
• The payments are made when the spouses or former spouses are living apart as a result of marital breakdown.
• The recipient has discretionary use of the amount (he or she can use the amount in any way).
• The payments are made in consequence of a decree, order or judgment of a competent tribunal or a written agreement.
Lump sum spousal payments are not taxable to the recipient or deductible to the person making the payment.
In general, amounts that are tax deductible to the payer are included in the income of the recipient which might bump you into a different tax bracket. Lastly, apart from taxes, please remember that the amount of support paid or received can have detrimental effects on your ability to qualify for a mortgage.
If you expect to receive spousal support payments or extra child support payments, you might want to increase the taxes deducted at source to avoid a massive tax bill when filing a return; this can be achieved by submitting form TD1.
14) Child support payments
Child support payments are defined as any amount not identified in the agreement or order under which it is made as being solely for the support of the recipient spouse or former spouse or the parent of the taxpayer’s child. Child support is tax exempt in the hands of the person who receives the support, and the person who pays it cannot claim the support as a deduction.
If the full amount of the required support payments is not made in the year, only payments more than the necessary child support payments are included in the recipient’s income and deductible to the person making the payment.
“The biggest financial pitfall in life is divorce. And the biggest reason for divorce is marriage” ~Gene Simmons
Tax issues can be daunting. Sometimes it may be hard for you to understand how to apply general information to your situation. Your divorce/ separation could be convoluted due to variables such as blended families, pension income from several sources; multiple ex-spouses or common-law partners; a significant amount of money involved ; and uncertain tax issues causing conflict between the separating /divorcing spouse or common-law partners.
Even if your situation seems straightforward, there may be some tax-related twists and turns. Changes in your marital status can have a significant implication on your taxes and your financial situation.
If you’re going through a divorce, don’t automatically expect the CRA or the courts to make reasonable decisions for your benefit as this may not happen.
Filing the final divorce papers may give you a sense of completion and closure, but the existing settlement proposals might not take into account the effect of taxes and the present value of money on the amount of support or the value of the properties to be divided. In this situation, your CPA can suggest an equalisation amount that takes these considerations into account.
To make sure you are not financially disadvantaging yourself with unwelcome tax surprise later, you should forward the analysis from your CPA to your legal counsel to negotiate a final settlement. Although even the most comprehensive agreement cannot guarantee CRA will agree with the positions taken, ensuring everyone understands the intended result should reduce future conflicts
“Note to Wealthy People Considering Divorce: Stay out of Court.” The Globe and Mail, The Globe and Mail, 15 Apr. 2017, https://www.theglobeandmail.com/globe-investor/globe-wealth/note-to-wealthy-people-considering-divorce-stay-out-of-court/article34321184/
“Grey Divorce Is All about the Math.” Canadian Lawyer Mag, 2 Mar. 2015, https://www.canadianlawyermag.com/author/jennifer-brown/grey-divorce-is-all-about-the-math-2800/
“Divorce Can Make a Mess of Tax Benefits.” The Globe and Mail, The Globe and Mail, 23 Nov. 2017, www.theglobeandmail.com/globe-investor/personal-finance/taxes/divorce-can-make-a-mess-of-tax-benefits/article37067214/
The information provided on this page is intended to contain general information. The data does not take into account your situation and is not designed to be used without consultation from accounting and financial professionals. Cloudiverse CPAs will not be held liable for any problems that arise from the usage of the information provided on this page.