Patricia Day, CPA, CA, CBV, TEP, Partner (retired)
After years of living together, you and your spouse have decided to split up. How are you going to divide your assets? Who gets custody of the children? These are, and for good reason, probably two of your biggest concerns. However, something that often gets overlooked is the effect a split will have on your taxes.
Divorce or separation can be devastating to a family, especially when there are children involved. However, this is the reality of the world we live in today and there are tax repercussions of which you need to be aware.
It is recommended that you contact your accountant to discuss your specific situation.
It should be noted that in some scenarios, despite the absence of a marriage certificate, you and your partner may be considered spouses in the eyes of the law. In 1993 the definition of a spouse, for income tax purposes, was broadened to include opposite sex common law partners. In 2001, same-sex common law couples were added to the definition.
For tax purposes, a common law couple is one that has lived together for at least one year or lives together with a common child. This is different from provincial rules for family law purposes.
For the purposes of this article, consider the fictional case of Knox and Tina whose marriage is ending after five years. They are splitting up in the middle of the year. They have two boys and have agreed to split custody of the children. Tina will receive child support and spousal support from Knox.
This article will cover spousal support, child support, claiming dependants, what legal fees are deductible, and the division of assets and property.
Spousal support
Spousal support and child support differ in the ways they are reported for your income taxes. If we use our example couple, Knox and Tina, Knox has been ordered to make monthly spousal support payments to Tina.
After sitting down and having a meeting with their accountants, Knox learns that his spousal support payments to Tina are deductible on his taxes and Tina learns that the spousal support payments she receives are taxable. Most income tax matters are determined federally, so these rules are the same regardless of where you live in Canada. Provinces tend to follow the same rules.
The exception to this rule is if the support comes in a lump sum, as opposed to periodic payments. Lump sum support is not deductible.
A signed separation agreement, or court order, must be in place before any support payments made can be claimed. If Knox were to decide to pay additional amounts not outlined in the separation agreement, those would not be deductible. A proper amendment must be made to the separation agreement for the payments to be eligible for claiming.
If an agreement is signed after payments have begun, payments can be deducted for one year prior to the signing, provided they are detailed in the agreement. It may be necessary to file an amendment to the prior return to claim the deduction or report the income.
Child support
As mentioned earlier, Tina and Knox are splitting custody of their two boys and, in addition to spousal support, Knox will be making child support payments.
As of May 1, 1997 child support payments were deemed not to be a tax deductible expense. Considering child support payments are not tax deductible, they are also not taxable for the recipient.
A grandfathering clause is in effect for those people who negotiated their child support payments before May 1, 1997. In other words, child support arrangements made before the amended laws are deductible.
In regards to claiming child care expenses, you must have partial custody of the children to do so. In the case of Knox and Tina, they can both claim child care expenses because of the shared custody agreement. Each can claim the maximum amount allowed per child.
Canada Revenue Agency allows for you to claim up to $500 on your tax returns per child for their physical activities, called a fitness credit. In the event of a divorce or separation, this fitness credit can be shared as long as it does not exceed the $500 limit.
Dependant credits
Knox and Tina’s marriage ended in May. For the past five years Knox has claimed his children, and Tina, as dependants on his tax returns. Since their split occurred during the taxation year, Knox can choose to claim either the spousal support or dependant credits. In the subsequent years, however, he can claim the support payments, but is not eligible for dependent credits.
However, as the recipient, Tina may be able to claim the eligible dependent amounts if they qualify
Deducting legal fees
The Canada Revenue Agency (CRA) has very specific guidelines in regards to what legal fees are considered tax deductible. Since 2002, legal costs incurred in an effort to obtain spousal or child support, or to enforce a pre-existing agreement, are now considered tax deductible. This only applies to the recipient of the support, not the payer.
However, any legal fee incurred in the process of dividing up assets or figuring out custody of children is not deductible.
Division of property and assets
One of Knox and Tina’s biggest concerns revolved around the tax consequences of withdrawing money from their Registered Retirement Savings Plan (RRSP) to split in half. The CRA allows for the transfer of funds between plans without tax consequences assuming:
- you and your former spouse are living apart;
- the payment is following either a judge’s order or a legal separation agreement;
- both you and your spouse are not disqualified by reason of age from having an RRSP; and
- the transfer is made directly between plans.
Just like the RRSP, property can be transferred on a tax-free basis between former spouses during a divorce. The recipient spouse assumes the cost base of the transferring spouse, assuming the inherent capital gain.
In the case of Knox and Tina, Tina receives an investment portfolio with a cost of $50,000 and a value of $75,000 which makes her inherent gain equal to $25,000. She will pay capital gains tax on the $25,000 when the investments are sold, while Knox incurs no tax costs for splitting his portfolio in half.
If Knox or Tina were to have a cottage or business, the tax issues become more complicated and professional advice should be sought.
Summary
It is not an event we look forward to in our lives, but the reality is divorces and separations are all too common in the world today. With divorce comes new tax rules and it’s important to understand them. Spousal support, child support, the division of assets, and legal fees are all a reality of the situation.
We would suggest professional tax advice be obtained when negotiating your separation agreement and to get assistance in preparing your tax returns for at least the year following separation.
