Tax traps for divorcing clients

Read Part 1 of this series here. Editor’s note: While this article was published in 2013, the author has confirmed that it is current for the 2016 tax year.

When clients divorce or separate, they often transfer assets to their former spouses as part of a legal settlement. But they don’t always consider the tax implications.

Read: Minimize tax on marriage breakdown

For instance, many have misconceptions about the attribution rules, a special set of tax rules that will tax income or gains to one spouse even though the other spouse receives the income.

When a relationship breaks down, many people think attribution automatically stops on all income and capital gains generated by the recipient spouse, but attribution may still apply.

Read: Divorce planning a modern “must”

In the case of income (interest, dividends, rents, royalties), the attribution rules cease applying upon relationship breakdown. So if property has been transferred pursuant to a written agreement or order, any income generated from the transferred property will automatically be taxed in the recipient spouses’ hands as long as both parties remain separated throughout the year.

Consider the fictional divorcing couple, Tom and Katie. Katie is transferring a $20,000 GIC, part of her non-registered portfolio, to Tom as part of their separation agreement. All interest income generated from the GIC after the date of transfer would be taxed in Tom’s hands as long as they remain separated throughout the year. The attribution rules will not apply.

Read: Divorce checklist

However, the rules are slightly different for capital gains in the case of relationship breakdown. While attribution automatically ceases for divorced couples, it doesn’t stop when parties are separated, but were never married or are not yet divorced.

In this situation, clients must take additional measures to ensure that attribution will not apply on triggered capital gains. They must:

• Live separate and apart by reason of marriage breakdown (and have not resumed cohabitation in the year), and
• File a joint election (under subsection 74.5(3)(b)) where they agree not to have attribution apply on capital gains triggered on the sale of transferred property.

They file this joint election by attaching a note to the tax return of the transferring spouse. Both parties must sign it. Without this step, any capital gain arising from the sale of transferred property will be attributed back to the transferor spouse if the clients are not yet divorced at the time the property is sold.

Read: Making spousal attribution rules work for you

So if Tom transfers his non-registered mutual fund portfolio to Katie in compliance with their separation agreement and Katie subsequently sells the portfolio for a capital gain, the attribution rules will apply and create a tax liability for Tom if, even though he and Katie are separated, they are not yet divorced and have not filed the above election.

Frank Di Pietro, CFA, CFP, is assistant vice-president of tax and estate planning at Mackenzie Investments. He can be reached at fdipietr@mackenzieinvestments.com.

Frank Di Pietro

Tax & Estate

Frank Di Pietro, CFA, CFP, is assistant vice-president of tax and estate planning at Mackenzie Investments. He can be reached at fdipietr@mackenzieinvestments.com.