Draft legislation has been released which will impact divorcing or separating couples, who are disposing of their main residence and/or transferring ownership to their former spouse or civil partner.
In the following article, Courtney Halifax examines how the new rules will in most cases yield additional CGT by reducing the reliefs available. Some useful examples illustrate how the timing of transactions can have a significant impact on the resulting tax liability.
As always, timing and detail are all important in maximising the relief available and so professional tax planning advice can be exceptionally valuable in such cases. We are able to offer expertise across our teams to provide tax, financial planning, valuation and accounting support and advice, including expert witness reporting where required in divorce proceedings or separation negotiations and settlements.
Capital Gains Tax & separation
Following on from the announcement in Budget 2018, draft legislation has recently been published on the changes to Principal Private Residence (PPR) relief and lettings relief which are due to come into effect from 6 April 2020.
These changes will need to be considered whenever an individual is selling a property which has at any time been their main home, and will have wide reaching implications. In particular, this article will focus on the impact the new legislation will have on separating couples where one party moves out of the family home either before it is sold, or before ownership is transferred to the other party.
Where are we now?
Currently PPR relief provides an exemption from CGT on an individual’s main residence (including grounds of up to half a hectare). An individual can only have one PPR at a time, and a married couple can only have one PPR between them; although this ceases to apply if the couple separate in conditions which are likely to be permanent.
PPR relief is available for any periods of time in which the property was occupied as the main home, as well as the final 18 months of ownership, regardless of any actual occupation during this period. PPR relief also extends to cover some situations where an individual has vacated their property out of necessity, for example, individuals who are seconded to work abroad, or have had to leave their residence to move into residential care.
No relief is available for any proportion of the home that is used exclusively for business purposes, including a letting business. For example, if a garage has been converted into a hairdressing salon or a standalone residential let annexe, no PPR relief will be given on the proportion of the gain relating to the garage. The split of the gain is usually computed on the basis of area, but any just and reasonable method of apportionment can be used.
HMRC accept that the position is different if the tenant is a lodger sharing communal spaces with the owner: ‘where a lodger lives as a member of the owner’s family, sharing their living accommodation and taking meals with them, no part of the accommodation is treated as having ceased to be occupied as the owner’s main residence, and the exemption will not be restricted at all’.
If the property has been rented out, either partially to a tenant who does not meet the lodging conditions, or in its entirety during a period of absence by the owner, then lettings relief is available to mitigate the capital gains relating to this period. For lettings relief to apply the property must have been an individual’s main residence for PPR relief purposes at some point in time.
Lettings relief exempts any chargeable gains relating to the let period on a time apportionment basis, subject to a maximum available relief of £40,000 (or the value of PPR relief available if lower).
Jessica and Michael separate on 1 October 2018 with Michael moving out of the family home on this date. Jessica continues to occupy the family home until it is sold on 31 March 2020 for £800,000. The property was originally acquired in April 2010 for £600,000, Jessica and Michael let the property out for the first three years of ownership before moving into the property in April 2013. A potentially chargeable gain of £200,000 has arisen on the sale of the property, split £100,000 each to Jessica and Michael.
Jessica has occupied the property as her main residence for seven out of ten years of ownership; therefore 70% of the gain will be covered by PPR relief (£70,000). Lettings relief will be available to cover the remaining three years (£30,000) so the gain will be fully covered by reliefs.
For Michael, the main home ceased to be his PPR on 1 October 2018. However, as the final 18 months of ownership are treated as being his PPR regardless of occupation, this means that the period 1 October 2018 to 31 March 2020 is covered, so his position is the same as for Jessica above.
What is changing?
From 6 April 2020, the final period exemption is being reduced from 18 months to 9 months. The only exception to this will be if the owner has had to move out of the property into a long term residential care facility, in which case a more generous 36 month exemption period will continue to apply.
For lettings relief an additional condition is being implemented which means that owners will only qualify for relief if they have occupied the property at the same time as their tenants, provided they were not carrying on a trade or business. This will therefore only cover a small percentage of cases where a tenant may not have sufficient integration to qualify as a lodger but the activity is not sufficient to qualify as a business.
Looking again at our example of Jessica and Michael, let us assume that all other facts remain the same but the sale does not take place until 30 April 2020.
Jessica has occupied the property as her main residence for just over seven out of ten years of ownership; therefore 70.25% of the gain will be covered by PPR relief (£70,250). As Jessica didn’t occupy the property at the same time as the tenants, no lettings relief will be available to cover the remaining three years. Therefore, Jessica will realise a chargeable gain of £29,750 which will result in CGT becoming due of £8,330 (assuming her annual exempt allowance for CGT has already been used).
Michael will also be unable to claim any lettings relief in respect of the three year let period. In addition, as the property ceased to be his PPR on 1 October 2018, the period 1 October 2018 to 31 July 2019 will not be covered by PPR relief. The final 9 months from 1 August 2019 to 30 April 2020 will be treated as being his PPR regardless of occupation. Therefore, three and a half years will be chargeable – or 37.5% of the gain. CGT will therefore be payable on £37,500 at 28%, resulting in a liability of £10,500 (again assuming no relief for the annual exempt allowance).
As you can see, delaying the sale by just one month could increase the potential CGT position considerably.
What if there is no sale but assets are transferred between the separating spouses?
There are a number of tax rules which apply to married couples. For CGT purposes the main point to note is that any transfers of assets between married couples living together take place on a no gain/no loss basis. This means that the recipient acquires the asset at their spouse’s base cost and no gain arises for the transferor.
For tax purposes we treat a couple as ceasing to be a married couple from the point of separation, rather than the start of divorce proceedings. Under legislation, separation is defined as the point at which couples are separated under a court order or in circumstances in which the separation is likely to be permanent.
Year of separation:
For the remainder of the tax year in which the date of separation falls, couples are able to transfer any assets on a no gain/no loss basis. This creates a significant benefit for couples who separate early in a tax year as a couple who separate on 10 April have until the next 5 April to transfer assets without a CGT charge arising, whereas a couple who separate on 1 April have only 5 days to take advantage of this treatment.
Even when transfers take place on a no gain/no loss basis, care needs to be taken if a property was not the main residence of both parties throughout ownership. Whether the recipient spouse inherits the transferring spouse’s ownership history depends on when the transfer takes place and how the property is being used at the time; more detail on this is provided in Alice Pearson’s article ‘Principal Private Residence Relief – changes from 6 April 2020’.
Subsequent tax years:
Following the tax year of separation, the two separated individuals are treated as connected parties for tax purposes until the date of the decree absolute. As a result, any transfers between the connected parties during this period will be treated as taking place at market value, regardless of whether any proceeds are actually paid or not. This can give rise to CGT liabilities for the partner disposing of their share of the assets.
These rules apply not only to the transfer of the main home but also to any other assets which are liable to CGT. This includes company shares and investment properties, as well as paintings and other chattels worth more than £6,000 (but excluding cars which are outside the scope of CGT).
Additional PPR relief on separation
The government are aware that divorce proceedings often involve lengthy negotiations, and so the transfer of the main home can fall outside the normal final period exemption. Consequently, additional PPR relief is available to mitigate the CGT on transferring the main home between parties in the course of divorce proceedings. This additional relief will not apply if the property is being sold to a third party.
PPR relief is extended up until transfer in the situation where one party disposes of their share in the property to the other party under a court order or other agreement made in contemplation of a permanent separation. In this situation, provided the transferee has continued to occupy the property as their main residence throughout the period since the transferor left the property, PPR relief will be extended from the date the transferor moved out of the property up until the date of the transfer.
There is no maximum time that can be covered by the relief, but it should be noted that the transferor will not be able to claim PPR relief on any other property during the extended relief period.
Looking back to our example of Jessica and Michael above, let us consider the position if the property were transferred into Jessica’s name in April 2020 as opposed to being sold. As the transfer is after the end of the tax year of separation it will be deemed to have taken place at market value. Assuming this is £800,000, a gain of £100,000 will arise on the disposal by Michael.
PPR relief will prevent any gain becoming chargeable for the occupied period and the final 9 months, so on first glance it would appear that the tax position would be the same as if the property were sold to a third party. However, as the property is being transferred to Jessica, who has continued to live in the property throughout the period of Michael’s absence then PPR relief will be extended to cover the period from 31 October 2018 through to 30 April 2020. As a result, the only element of the gain which would be chargeable to tax would be the first three years which relate to the let period, resulting in a gain of £29,750.
If Michael had acquired a new property in October 2018, then by claiming the extended relief on his former family home, he will be forfeiting any PPR relief for the same period on his new home. As such he will only be entitled to PPR relief on his new home from May 2020 meaning the first 19 month period will be chargeable on any future sale of the new property.
Other areas to think about in the event of a divorce
As well as the family home, divorce proceedings can involve the transfer or disposal of all manner of assets. The treatment of any of these assets is fundamentally influenced by timing and where possible this should therefore be considered and planned.
Transferring assets in the case of a divorce is an area in which Mercer & Hole can offer support. This may take the form of tax advice and planning points, including calculations, or could involve a formal report by our dedicated Expert Witness team, many of whom are members of the Resolution network which is a network of professionals committed to the constructive resolution of family disputes. Our aim is to provide high-level impartial opinions and guidance across a range of areas.
Determining the latent capital gains tax position on the transfer of a portfolio of rental properties is an area with which we are often called upon to assist. We pride ourselves on not only supplying reliable calculations, but also providing advice on the various ways in which the tax arising on such transfers can be mitigated. For example, if a couple intend to swap a number of rental properties owned jointly so that they each have their own separate portfolios it can be possible to prevent a dry tax charge from arising by claiming holdover relief, provided certain conditions are met.
As well as investment assets, consideration should also be given to what fair value should be placed on private businesses, and this is something we can assist with through provision of an impartial valuation. In this connection it is often necessary to explore the tax implications of monies being extracted to fund settlement agreements, and the implications of share ownership not only at the time of any transfers but also considering the progression of the company in future.
Another increasingly important area being explored in divorce is how pension assets can be dealt with using pension sharing orders and other available mechanisms for division. This is a speciality of our Financial Planning team who are all chartered individuals and regulated to provide independent advice in this area. As part of our holistic approach to our clients’ affairs, our financial planning team also frequently provide cash flow forecasts to assist individuals in determining whether a proposed settlement agreement will be sufficient to provide for their lifestyle going forward.
Our Expert Witness team can provide specialised opinion across these areas and more, taking into account sustainability, tax efficiency and feasibility. If you feel that anything discussed above may potentially affect your situation, please do not hesitate to contact your usual Mercer & Hole contact, or a member of the Expert Witness team to discuss your own circumstances in more depth.