How Property Is Taxed During Separation or Divorce

Ask MoneySense

What happens if a married couple separates and they own a family home and a cottage? The separation is amicable and they want to divide the properties so the family home goes to the wife and the cottage goes to the husband. Would that trigger any taxes?

—Peter

Separation raises many financial questions, including tax consequences. In the scenario you describe, there are tax rules that govern transfers between spouses, how the principal residence exemption can be applied, and other provincial or transactional charges to consider. Below is a clear overview of the key tax implications to help you plan an equitable split.

How an asset transfer between spouses is taxed

Transfers of property between spouses (or common-law partners) are generally treated as tax-deferred transfers. In practice, this means that when one spouse transfers ownership to the other, the transfer can occur on a rollover basis at the property’s original purchase price, often referred to as the adjusted cost base (ACB). That rollover avoids immediate capital gains tax at the time of transfer.

Couples also have the option to elect a transfer value anywhere between the adjusted cost base and the fair market value (FMV). Choosing the FMV at transfer will crystallize any capital gain for the transferor, while electing the ACB defers that tax until a future disposition. The choice should be made with tax planning in mind, since it affects who will eventually pay tax and when.

Watch for spousal attribution

Spousal attribution rules can shift income or capital gains back to the transferor when assets are moved between partners. Attribution generally applies while a couple remains married or in a common-law relationship: if one partner contributed most or all of the funds to acquire an asset and then transfers it, income or gains from that asset may be attributed back to the original contributor.

However, attribution rules do not apply once the couple has legally separated or divorced. After separation, each person can own property outright without future income or gains being attributed to the former spouse. That said, past contributions and the timing of transfers can create lingering tax consequences that should be considered and documented as part of any separation agreement.

How the principal residence exemption applies in separation or divorce

Only one property can be claimed as a principal residence for any given tax year. Importantly, the principal residence is not necessarily the residence you occupy most of the time — couples can choose which property to designate, including a cottage, provided it meets the rules for the principal residence exemption.

When separating amicably, spouses should agree on which property designation minimizes overall tax. That often means comparing the annualized capital appreciation of each property: take the total increase in value and divide by the number of years owned to estimate where the most tax savings would accrue.

For example, if a couple owned a cottage that appreciated rapidly over a short period, they might agree to designate that cottage as the principal residence for the years they owned it. The spouse transferring the cottage could elect to transfer ownership at fair market value so the principal residence exemption applies in the transfer year. The remaining home might then be treated as the other spouse’s principal residence for years outside the cottage’s designation.

Because only one property can be claimed in any year, claiming the cottage for certain years will reduce the years available to claim the house. That can create a future capital gains exposure for the spouse who keeps the house. To address this, couples frequently adjust the equalization payment: the spouse keeping the property that will carry a future tax burden may receive additional cash or assets to compensate for the expected tax liability.

Other tax considerations

Beyond income tax and the principal residence rules, there are other potential costs when transferring property between spouses. Land transfer tax, municipal charges, or provincial filing requirements can apply depending on where the properties are located. Some jurisdictions provide exemptions for transfers made pursuant to a separation or divorce agreement, but rules vary by province, territory and municipality. Be sure to confirm local requirements before finalizing transfers.

Have the assets been equitably split?

Equalizing assets on separation means more than simply dividing dollar values. Different types of assets carry different tax consequences. For instance, an RRSP will incur tax when withdrawn, while a TFSA does not. Similarly, a house that will incur capital gains when sold is not equivalent to cash sitting in a bank account. Each party should work with their accountant and lawyer to model the after-tax value of the assets each will receive and ensure the division is truly equitable.

Documentation is important: a clear separation agreement that records valuations, transfer elections (for tax rollovers or FMV), and any compensating payments will reduce the risk of unintended tax consequences later on.