Quick Guide to Tax Consequences of a Family Law Property Settlement
In a family law property settlement, capital gains tax that is usually payable on the net profit made on the sale, transfer or disposal of property to another person, is usually deferred until a later sale by the person to whom the property is transferred’. There are exceptions to this rule that are due to different income tax rules may/may not apply to your divorce proceedings.
This article is a quick guide to tax consequences to consider when contemplating a Family Law Property Settlement.
Please note: The reference to spouse in this article also refers to a de facto spouse.
The Family Home
As a general rule, capital gains tax is payable on the net profit made on the sale, transfer or disposal of property to another person.
However, the family home is exempt provided it has been used for the whole period of the combined ownership by its owners and provided its owners were the spouses themselves.
In a family law property settlement, it is common for the family home to be retained by one spouse. This often requires the other spouse to transfer their interest in the home to that spouse. This is a valuable asset for a party to retain as there will be no tax payable on any net profit made on the sale of the home in the future.
If the home was owned by a company or trust and it is to be transferred to a spouse the exemption from capital gains tax cannot be claimed for the period the home was owned by the company or trust. This means that upon its eventual sale, tax may be payable on any net profit made on the sale of the home.
For the purposes of being exempt from capital gains tax, the home and surrounding area must be less than 2 ha in size.
Other Real Estate and Assets and `Roll Over Relief’
Special rules apply to the transfer of an asset (other than the family home) from one spouse to the other when the transfer is pursuant to an order, financial agreement or arbitration award under the Family Law Act. These rules apply to automatically defer the liability to pay capital gains tax until such time as the asset is sold. This means that the spouse to whom the asset was transferred will be liable to pay the tax on any gain made on a subsequent sale of the asset.
It is not just real estate that may be subject to tax upon sale or transfer. It includes other assets such as shares, leases and rights of various kinds.
There are often disputes regarding whether an estimate of the amount of tax payable on the future sale of a property should be a cost shared by both parties rather than just by the party acquiring the property.
Capital gains tax is also payable on the sale or disposal of:
- collectables such as artwork, jewelry or antiques or a wine collection if that asset was acquired for $500 or more; and
- personal-use assets such as a boat if that asset was acquired for more than $10,000.
The special rules above regarding `roll over relief’ in a family law property settlement also apply to the transfer of these assets if the transfer is pursuant to an order or agreement under the Family Law Act.
Foreign resident capital gains withholding tax
Foreign resident capital gains withholding now applies to vendors disposing of real property under contracts entered into form 1 July, 2016.
Purchasers of property are required to withhold 12.5% of the purchase price and pay this to the Australian Taxation Department where the market value is $750,000 or more. This also applies to property owned by a company through which the vendor has an indirect interest.
Unfortunately, this law has caught transfers of property between separated Australian resident parties where the transfer is in accordance with a family court order.
In order to avoid paying 12.5% of the market value of a property to the ATO, the party who is transferring their interest in a property must obtain a clearance certificate and provide it to the other party before the property is transferred into their name.
Parties must therefore incur the extra cost for their accountant or conveyancing lawyer to obtain a clearance certificate. It is therefore advisable for parties to obtain a clearance certificate once it becomes clear that a relationship property that is worth $750,000 or more is to be transferred to one of them as part of a property settlement. This will ensure that when the time comes, such transfers can proceed without delay.
Special rules apply to the division of superannuation between spouses on a relationship breakdown. Transfers of a spouse’s entitlement in a superannuation fund to another spouse are disregarded for capital gains tax purposes provided the transfer is pursuant to a court order or binding financial agreement.
Where there is an in-specie transfer of an asset between self-managed superannuation funds that transfer is subject to roll over relief.
Unpaid Present Entitlement
It is common in a marriage or defacto relationship for income to be split between both spouses. This is most commonly achieved by way of a family discretionary trust and of which both spouses are beneficiaries.
At the end of every tax year, all income earned by a trust must be distributed to the beneficiaries. In the case of the spouses, they will each be presently entitled to a share of the trust income. Even though the trust’s financial accounts will show the trust income as allocated it is not necessarily the case that spouse beneficiaries will have physically received the income.
The income that is owed but not actually paid to the spouses is known as an Unpaid Present Entitlement. Should a spouse have such an Unpaid Present Entitlement, they would be entitled to this payment in any family law property settlement agreement. One way of dealing with this entitlement is for that spouse to agree to assign their right to this payment to the other spouse. This results in no money changing hands and the spouse to whom the right is assigned often retains the trust.
Spouses who are beneficiaries of a family trust are frequently not aware that they have an Unpaid Present Entitlement. If this is the case then it is a benefit that such a spouse may miss out on (by assigning their right to this payment to the other spouse) in a property settlement.
As part of a family law property settlement, a spouse may wish to remove the other spouse as a beneficiary of the trust they are to retain. In the past there has been concern that the act of removing a beneficiary from a trust would constitute a trust resettlement. This may result in significant stamp duty to be paid by the spouse retaining the “new” trust. There would also be tax consequences for the unintended creation of the new trust from an existing trust.
It is now accepted that there will only be a termination of a trust in very limited circumstances and the removal of or addition of a beneficiary will not mean the creation of a new trust.
Companies – loans, debts and payments
It is common for spouses to operate a business through a company and for those spouses to be directors and shareholders of that company. In a family law property settlement it is usual for one spouse to leave the company and for the other spouse to retain it. This is achieved by leaving spouse transferring his or her shares in the company to the remaining spouse. Usually there are no tax consequences arising from the transfers of shares in small family companies of this kind.
A hidden tax danger with family companies is when property owned by the company is to be transferred to a spouse as part of their property settlement agreement. This will trigger a taxation consequence such that the value of the property to be received will be regarded as an unfranked dividend and will form part of the receiving spouse’s taxable income on which they will pay income tax. If the asset is of significant value this could result in a sizable tax liability for the receiving spouse.
Another hidden danger lurking in family companies is where either spouse as a shareholder or an `associate’ of a shareholder spouse owes a debt to the company or has loan from the family company. This debt or loan will likely have arisen during the relationship and the funds will have been used for the benefit of the whole family. This debt cannot be forgiven or written off.
These liabilities will need to be repaid to the company and this obligation to repay the company should be part of the family law property settlement agreement. The usual method of repayment is by way of a loan agreement that provides for repayment to the company within a certain time. Should this not happen, the spouse who owed the debt or had the loan from the company will have the amount of the debt or loan included in their assessable income as a deemed dividend and will be liable for the tax on that notional income amount.
As a general rule, stamp duty is not payable on the transfer of an asset (located in Queensland) from one spouse to another or to one of their entities provided is pursuant to an order or financial agreement made under the Family Law Act.
Maintenance payments made by a spouse or that are attributable to a payment made by a spouse is exempt income of the receiving spouse.
If a spouse receives income from an existing trust as maintenance payments instead of directly from the other spouse, tax will be payable on that income.
Similarly, if the maintenance payment is diverted income which the maintenance payer would otherwise be liable to pay tax on, the receiving spouse would have to pay tax on that maintenance payment.
It is possible to fulfill an obligation to pay maintenance to a spouse by paying that spouse a single lump sum payment. As this payment is capital there will be no tax consequences upon its payment but it may affect a receiving spouse’s entitlement to other benefits.
It is possible to meet child support obligations from a source other than the parent’s income when there has been a relationship breakdown. This can be a very cost effective way to meet child support obligations.
This can be achieved through the establishment of a Child Maintenance Trust where the beneficiaries include the children of a parent who has a maintenance obligation pursuant to a family law property settlement.
The most common way to derive income to be earned by the trust is through the transfer of an asset to that trust. The asset then earns income for the trust which is then made available for the financial support of the children.
The children must receive the asset when the trust comes to an end.
If your relationship is at an end and or a separation seems likely we can provide advice on your particular financial circumstances as well as advise on the most tax-efficient way of reaching a family law property settlement with your spouse. Where possible our approach to resolving disputes or difficulties involving families is conciliatory and constructive.
If you do not have a lawyer assisting you and would like advice on your particular financial circumstances please contact us. We will work closely with your accountant and we also have access to specialist tax lawyers who can provide tax advice, if needed.
This Quick Guide is intended as a source of general information only. This means this Guide is no substitute for advice that is specific to your circumstances. You cannot rely on it for completeness or accuracy of its contents in any particular situation.