Transfer of Property between Spouses is a Taxable Event –Introduction
This article is part two of the five parts "Election Series" whereby the tax consequences and available election for inter-vivos transfer of property between spouses is discussed.
Generally, transfer of property between individuals is a taxable event. This is so even if the property is gifted from one person to another. Spouses are no exception to this rule.
Many taxpayers may be surprised to know that gifting a property, such as stock portfolio, to another person can be a taxable event. The term "taxable event" refers to transactions that result in a tax liability for one or all the parties involved.
For example, transfer of a cottage or even part ownership of a house from one spouse to another is a taxable event. For example, when one individual conveys a house to another, the transfer can result in capital gain.
The term "spouse" is defined broadly in the Income Tax Act (the "Act") and includes married spouses, common law partners, and two individuals who have been living in a conjugal relationship for at least 12 months. It is important to note that two individuals can meet the definition of "spouse" even if they have never been married or lived together: two individuals who have a child together (adopted or biological) are considered spouses.
This article is the second in a four part "Election Series" articles where the particular tax liability resulting from the transfer of property from one spouse to another is discussed. The Income Tax Act has a default set of rules that apply to the transfer of property. The Act also offers an election, whereby the spouses can elect to have a different set of rules apply to them. The tax consequences for the two spouses under the default rule and the election vary. While the election offer spouses the opportunity to engage in tax planning, if followed incorrectly, the transfer of property can result in unreported income.
Tax Consequences of Transfer of Property Between Spouses
Transfer of Property Between Spouses takes Place at Adjustable Cost Base
Generally, when a property such real estate is transferred between two non-arm's length individuals, the Act assumes that the transferor (the person transferring the property), received fair market value ("FMV") consideration for the property. This is so even if the property was a gift. This rule has immediate tax consequences for the person transferring the property: if the FMV is greater than the transferor's adjusted cost base ("ACB") of the property, he must recognize and report capital gains when he files his income tax return for the year unless a capital loss was realized.
The default rule for transfer of property between spouses is rollover treatment meaning that there is no immediate tax liability that arises as a result of the transfer of property from one spouse to another. When one spouse transfers a property to his or her spouse, the Income Tax Act assumes the transferor, received consideration equal to the ACB of the property. As a result, no capital gain or losses arises from that transfer .
For example, if spouse A purchases a stock for $100 and transfers the stock spouse B at a time when the stock is worth $500, there are no tax consequences for spouse A. The CRA assumes that spouse A received $100 for the stock from spouse B. In turn, the cost of acquisition of the stock for spouse B is $100.
In essence, the default rules allow spouses to defer recognition and reporting of any capital gain or losses that would otherwise have to be reported. However, it is important to note that this deferral of capital gain or losses stops once the spouse who has received the property, sells it to a third party. At that point, any capital gain or losses must be recognized.
In the above example, if immediately following the transfer of the stock, spouse B sells the stock in the open market, the $400 capital gain must be recognized and reported. The default rules of the Act state that it is spouse A, and not spouse B must recognize this capital gain in his or her income for the year of disposition. Failure of spouse A to recognize this capital gain in his or income results in unreported income, and will be a problem if spouse A is audited by the Canada Revenue Agency (the "CRA").
Transfer of Property Between Spouses Results in Attribution of Capital Gains and Income to the Transferor
When property is transferred from one spouse or common law partner to another, any capital gain or income from the property is attributed to the transferor. The attribution rules can be complex and will be discussed in more detail in the third part of the Elections Series.
Transfer of Property between Spouses: Making an Election under subsection 73(1)
The Act allows the transferor to make an election under subsection 73(1) so that the spouse taxpayers can to elect out of and suspend the default rules of rollover treatment and attribution.
There are two consequences in making this election. First, the transfer of property is deemed to take place at FMV and not at ACB. This means that the spouse transferring the property must recognize and report any capital gain or losses arising from the transfer in the year that the property is conveyed to the other spouse. This rule applies even if there is no actual payment made from one spouse to another. The second effect of the election is the cost of acquisition of the property for the spouse that received it. Unlike the default rules, the receiving spouse uses FMV for the cost of the property.
Overall, the effect of making this election on capital gain is as follows: the recognition of the capital gain is not deferred. The spouse who transfers the property to another spouse immediately recognizes and must report any capital gains or losses that arise. Second, once the spouse to whom the property is transferred sells the property, any capital gains or losses must be recognized in his or her income tax filings for the year of transfer.
The election, in addition to suspending the attribution of capital gains and losses, also sets aside any attribution of income to the spouse who first owned the property. For example, if a husband transfers his dividend yielding stock portfolio to his wife, and subsequently makes an election under subsection 73(1), any dividends received by the wife must be included in the wife income. Attribution rules no longer apply.
Election under subsection 73(1) is a great tax planning tool for spouses with different tax brackets. However, it is important to seek legal advice prior to implementing this election as stop loss rules may prevent or defer recognition of losses by the spouses.
Tax Planning Tips: Election Permits Income Splitting Between Spouses in the Long Run.
The default rules described in this article prevent income splitting between spouses. For example, there are no tax savings when one spouse in a high income bracket transfers an income generating property, such as stocks or rental property, to the spouse who has a lower marginal tax rate. All the income generated is simply attributed to the spouse who transfers the property: the spouse with a higher marginal tax rate.
Making an election under subsection 73(1) is one way of splitting income with the spouse in a lower marginal tax rate. Once an election is made, and the property is subsequently sold to a third party buyer for fair market value, or if the transferred property generates any income that is following the transfer received by the transferee, the capital gain or income, following the election, should be included in the transferee's income.
Several tax planning options under this subsection are available to spouses who are in different tax brackets. In most instances, advice from one of our experienced Canadian tax lawyers is a prerequisite in ensuring that the required procedures under the Income Tax Act are followed and that the most favourable tax planning results are obtained.
Tax planning: Divorce and Separation Agreements: Where Election out of the Default Rules is Worth Closer Examination
Break down of a relationship is inevitably accompanied by division of assets. Such division often includes transfer of assets from one spouse/partner to another. The default rules of rollover treatment and attribution rules described above apply to such transfers. Failing to take the hidden tax cost of such transfers into account can very well result in uneven division of assets when spouses or partners have intended otherwise. The advice of an expert Canadian tax lawyer is able to determine the best tax treatment.
Tax Planning: Making an Election For Depreciated Property Requires Closer Examination.
The cost of executing an election under subsection 73(1) is often insignificant. However, whether making such an election is suitable depends on a particular set of facts of the two spouses. This is especially the case when the property being transferred has depreciated considerably. When certain facts are present, transfer of property between spouses can disallow the use of the capital loss by either spouse. It is important to seek advice from an experienced Canadian Tax Lawyer when arranging your affairs in reference to a capital property with significant loss.
The election and tax consequences discussed in this article only apply to transfer of property between spouses while they are both alive. These rules do not apply to any transfer of property that take place following the death of one of the spouses. In the next part of the series, the tax consequences and available election that govern transfer of property from a deceased spouse to a living one will be discussed.