Tax Issues on Marital Breakdown
When a marriage or common-law relationship fails, there are a number of issues that need to be dealt with and the tax issues may not be at the top of the list for the former couple. However, there are numerous tax rules to consider, and some are beneficial which can make a difficult situation easier to deal with.
Although the issue will usually be obvious, we still need to review who is and isn’t considered to be married for income tax purposes. In addition to individuals who have married each other in the traditional way, our income tax rules recognize “common-law” unions, which include same-sex couples. Two individuals (who aren’t otherwise married) are generally considered to be spouses for tax purposes if they have been living together in a conjugal relationship and have been living in such a relationship for at least 12 consecutive months or have a child.
The timing is somewhat different for legal marriages and common-law relationships. In a legal marriage, the couple typically separates for a time, and then the relationship ends when the couple obtains a divorce.
In a common-law relationship, the couple will no longer be spouses when they live separate and apart for at least 90 days due to a breakdown in their relationship (the relationship is deemed to end on the first day they separate).
For purposes of determining when a couple is separated for tax purposes, the 90 days rule is also applied to legal marriages, so once a legally married couple has been separated for 90 days, the effective day they separated is the day they started living separate and apart.
In the rest of this article, references made to a spouse include a common-law partner and a marriage includes a common-law relationship.
An end to a marriage can trigger two important events—a division of family assets, and the payment of support to a partner as spousal support (alimony) or child support.
Tax Rules for a Division of Assets
Under family law, a breakdown of a marriage may result in a requirement to divide assets. For income tax purposes, rollovers are available for these asset transfers, which allow an accrued gain or income inclusion to be deferred until the asset is disposed of or liquidated, as follows:
Capital Property – Property can be transferred between spouses at its tax cost. This means that no tax will arise on the transfer, and tax will not arise until the asset is sold. Income attribution may or may not apply, depending on the circumstances. The couple can also elect to divide property as a fair market value disposition, to utilize capital loss carryforwards or the capital gains exemption in the case of qualifying property.
RRSPs – Funds can be transferred on a tax-deferred basis from the RRSP of one spouse to an RRSP for the other spouse where the transfer is made in settlement of property rights. In addition, the transfer must be made pursuant to a court order or written separation agreement. Similar rules apply for RRIFs.
Canada Pension Plan Credits – Although exceptions apply, CPP credits of both spouses will generally be combined and split on the end of their marriage.
Tax Treatment of Support Payments
Again under family law, one spouse may be obligated to pay spousal or child support to the other spouse on the breakdown of the marriage and we’ll address how these payments will be taxed when an obligation does arise.
Spousal support payments (payments made solely for the support of the spouse) are generally deductible to the payer, and taxable to the recipient. However, there are conditions to be met—the most important being that the payments must be periodic (as opposed to a lump sum) and must be made pursuant to a court order or agreement. However, a lump sum which is a payment of periodic amounts in arrears will generally be treated as a periodic payment.
In the case of child support, the payment will generally not be deductible to the payer and won’t be taxable to the recipient. An exception applies for orders or agreements made before May 1997 (where the tax treatment will generally be the same as for spousal support, unless the former spouses elect jointly to be subject to the current child support rules).
Where an agreement or court order calls for both spousal and child support payments, the payments will be allocated first to the child support obligation.
For child or spousal support recipients, legal fees are deductible if paid to collect late support payments, to establish a support payment entitlement, to increase a support payment entitlement or to make child support payments non-taxable.
From the payer’s perspective, legal fees paid are generally not deductible. Also, fees related to custody of a child or visitation issues are not deductible.
Personal Tax Credits – Where a couple has dependants, they will have to determine which spouse can claim personal credits. In particular, if both spouses don’t enter into a new marriage, this means each spouse has the ability to claim a dependant as an “eligible dependant”, meaning that the credit amount will be the same as the basic personal credit (subject to a reduction based on the dependant’s income).
The eligible dependant amount may be claimed as long as the following conditions are met:
- the taxpayer does not have a spouse or common-law partner, or if there was one, the taxpayer was not living with, supporting or being supported by that spouse or common-law partner,
- the taxpayer supported a dependant in the year who lived with the taxpayer in a home maintained by the taxpayer (this would include dependants living away from home while attending school as long as the dependant ordinarily lives with the taxpayer when not in school) and
- the dependant supported is the taxpayer’s child who is either under 18 years of age or mentally or physically infirm (note that other individuals are eligible but in the context of this article, we are only referencing a child of the taxpayer).
A taxpayer can claim an eligible dependant if the above criteria are met, the taxpayer is not claiming a spouse or common-law partner amount and the taxpayer is not making support payments for the dependant. This claim can be made in the year of separation (a special rule also applies for support payments).
As only one spouse can claim this amount for a particular dependant, the former spouses will have to determine who will make the claim if both are eligible. A common planning idea where there is more than one dependant is to allow each spouse to claim one dependant each as an eligible dependant (if possible).
Child Care Expenses – Separation impacts the claim for childcare expenses. Separated or divorced parents may claim the deduction for childcare expenses based on the percentage of time the child(ren) resides with that parent. For example, in a 50-50 shared custody situation where each parent pays for 1/2 of the childcare costs, each parent can claim 50% of the child care expenses deduction.
Tuition and Education Credit – Where the parents of a student are separated or divorced, the student can transfer the unused portion of their tuition, textbook and education credits to either parent subject to the usual rules (but not a portion to both). As the transfer of the credit is not based on whether a parent actually supports the child or even pays the amounts for the child, the former spouses and the student will have to come to some agreement if there are credits to be transferred.
Principal Residence Rules – As a couple can only designate one residence, the couple will need to decide how the exemption will be used when more than one residence is held. The agreement/order should specifically address how the principal residence designations will be claimed on future sales.
Joint and Several Liability – The rules are complicated, and the key point to keep in mind is that a transfer of property could result in a joint and several liability for the associated tax in some situations.
This article has described, in general terms, just some of the important points that need to be considered on the breakdown of a marriage. It is crucial to get specific tax advice when agreements are prepared and tax returns are filed.
Your BDO advisor can guide you through the tax issues that arise on a marriage breakdown. Contact your advisor with any questions or concerns that you may have.
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