Mark and Beth jointly own a house and a cottage. They recently separated and, as part of their separation agreement, Mark will transfer his 50% interest in the house to Beth, and Beth will transfer her 50% interest in the cottage to Mark. Each intends to occupy their respective property as their principal residence going forward.
In discussing these transactions with their legal and tax advisors, the following questions arise:
- Can the transfer of their respective interests in each property be completed on a tax-deferred basis?
- Will future gains or losses on the properties accrue to the recipients (as opposed to the transferors)?
- When each property is sold in the future (or when the owner dies), will the principal residence exemption (PRE) be available to each spouse to fully shelter their property from tax?
Tax-deferred transfers between spouses and common-law partners
The transfer of capital property (which, in many cases, includes real property) between current or former spouses or common-law partners normally occurs at cost. This means that, unless the parties elect otherwise, the transfer occurs on a tax-deferred rollover basis, deferring capital gains tax to a future sale (or death).
Applying this rule, Mark can transfer his 50% interest in the house to Beth and Beth can transfer her 50% interest in the cottage to Mark, both on a tax-deferred basis. Doing so would postpone the realization of accrued gains and losses until the owner sells (or is deemed to have sold) the property.
Attribution and the taxation of future capital gains/losses
Normally, where property is transferred between spouses or partners, unless fair market value consideration is received in exchange, future income and capital gains (or losses) from the property are attributed (i.e., taxed) to the transferring spouse and not the recipient of the property.
However, the tax rules provide that when spouses live separately due to the breakdown of their relationship, attribution of future income and — upon election by the spouses — capital gains cease, resulting in taxation of income and gains to the recipient spouse.
In Mark and Beth’s scenario, if there is a taxable capital gain when the house is sold, the gain would be taxable to Beth solely if she and Mark choose this treatment. The same would be true for Mark when the cottage is sold. Attribution of gains ceases to apply beginning in the year the joint election is filed, and it can be filed at any time after separation.
The attribution rules don’t apply after divorce, so the election isn’t required if the property is sold after the divorce is finalized.
What about the principal residence exemption?
When there is a tax-deferred rollover of a property to a spouse or partner (current or former), the tax rules state that the property shall be considered to have been the principal residence of the spouse for any taxation year where the property was the principal residence of the transferring spouse or partner.
In other words, when she sells the house, Beth will be deemed to have owned a 100% interest in the house even during the years when it was jointly owned with Mark. The house will also be Beth’s principal residence for those years (provided she satisfies occupancy and other conditions).
With respect to the cottage, assuming both properties were purchased after 1981 (when PRE rules changed), only one property can be claimed as a principal residence by Mark and Beth’s family unit for the pre-separation period.
If the house is sold first and is designated as their principal residence for the pre-separation period, the exemption would not be available for the cottage for the same period. This would be an unfortunate result for Mark and should be considered when drafting their separation agreement. When Mark sells the cottage, he would only benefit from the PRE for the years following his separation.
The federal government provides information on the principal residence exemption and related rules, and the Canada Revenue Agency shared its comments by way of technical interpretation #2007-0234521E5.
Separation and divorce present challenges, and complexity is normally the case both emotionally and financially. Understanding the tax implications of a property transfer can help improve the outcome for your clients.