Although the tax implications of relationship property settlements are rarely front-of-mind, they can have significant consequences. It is important any tax implications are properly considered and reflected in the agreement to achieve a fair settlement. This article discusses the general tax principles relating to the settlement of relationship property, including the potential effect of the new ‘bright line’ test for residential property recently introduced on 1 October 2015.
The general rule
For relationship property purposes, the general rule is that the transfer of property under a settlement of relationship property does not trigger an income tax obligation. However, that does not prevent an income tax liability arising should the transferee subsequently dispose of the asset.
This is different from the position in the normal course of business, where the sale of business assets will generally be treated as a taxable event, triggering likely tax consequences. This includes tax consequences on business assets which are sold or realised prior to the settlement of relationship property with the intention of using those proceeds in the settlement.
Relief from income tax for relationship property purposes covers a range of assets commonly used in business, including shares and options, land, timber or timber rights, patents, trading stock, livestock personal property and leased assets.
While the transfer of property under a settlement of relationship property does not usually trigger an income tax obligation, this does not mean any income tax obligation relating to the property will be eliminated, just that the responsibility will be transferred to the new owner along with the property and so effectively deferred to a later time.
On transfer, this means the new owner acquires both the property and also its tax-relevant characteristics. This includes the transfer of the owners’ intentions at the date of acquisition. For example, if ‘John’ purchased a classic car with the intention of later resale, any subsequent gain on sale made would be likely to be taxable. If this car was then transferred to ‘Jess’ on separation, she would not only receive the car but also the ‘intention’, meaning any subsequent gain on sale would remain taxable income. The transferee essentially steps into the shoes of the transferor, and so they should be aware if any such intentions exist, prior to agreeing to the asset transfer.
Who do (and don’t) the concession rules apply to
To qualify for the relief described above, the property transfer must be made under a settlement of relationship property, involving the parties to a relationship property agreement.
Currently, only married couples, the parties to a civil union, or people in a de facto relationship, are defined as parties to a relationship property agreement. This means that if your clients agree on other options for dealing with their assets, such as transferring property into a trust, the tax concessions cannot apply (because the trust is not a party to the relationship property agreement).
This may create unintended tax consequences. For example:
A couple decide to separate after 10 years together. They have entered into a relationship property agreement and agreed that the husband will transfer the commercial property that was owned by him personally to a trust settled by the wife. The husband has claimed $50,000 in building depreciation (before 2011) and the property has increased in value.
As the transfer to the trust does not qualify as a settlement of relationship property, the tax concessions that would otherwise apply are not available. The husband will have to declare $50,000 of taxable income (depreciation recovered) in the year of transfer.
To counter situations like this, amendments have been introduced that will broaden the circumstances when the concessions will be available. These proposed changes are contained in the Taxation (Annual Rates for 2015–16, Research and Development, and Remedial Matters) Bill. The revised definition of ‘settlement of relationship property’ is:
“a transaction under a relationship property agreement that creates a disposal and acquisition of property between -
(i) a person who is a party to the relationship agreement or is associated with a party to the agreement:
(ii) another person who is a party to the relationship agreement or is associated with a party to the agreement:”
At the date of this article the Bill has been through its second reading, and so appears likely to be passed in its current form. The changes will take effect from enactment with no retroactive change, so they will not affect the financial position of anyone who has previously settled relationship property.
Be aware of the bright-line
Recent changes to the tax rules made with a view to dampening the strong Auckland residential property market now mean that where residential property that is not a primary residence is sold within two years of acquisition, any financial gains are generally subject to tax at the owner’s marginal rate of tax.
In particular, on 1 October 2015, what is referred to as the ‘bright-line’ test came into play to help tax authorities identify residential property transactions that fall into this category.
As explained, the transfer of property under a relationship property settlement is not currently considered a taxable event. Accordingly, the transfers of property under a relationship property agreement will not be subject to a tax liability under the ‘bright-line’ test. The property is deemed to have been transferred at cost and the original acquisition date still applies.
However, any subsequent sale of the transferred property may be subject to the bright-line test, if it occurs within the two year period from when it was purchased. While this doesn’t apply to the main home, it does cover any holiday homes or rental properties.
The introduction of the ‘bright-line’ test indicates the need to identify any residential properties (other than the family home) that have been acquired after 1 October 2015, as these could give rise to a potential tax obligation following separation for the party to whom the property is transferred if held for less than two years.
There may also be a value impact on the property for relationship property purposes due to a reduced ability to sell the property in the short term without triggering a tax liability. This is particularly in situations where one of the parties is forced to sell the property due to their changed personal circumstances. As such, where the sale of the property appears likely or necessary at the separation date, it may be that the relationship property settlement reflects this tax liability in some way or provides for some form of tax warranty should a liability arise.
While the general rule is that transfers of relationship property do not give rise to a taxable event, this does not mean tax implications can be ignored. As the new “bright-line” test on residential property demonstrates, tax considerations can directly impact the values at which relationship property is settled and so should be carefully considered as part of any settlement discussions.
This article appeared in Volume 17 Issue 2 of The Family Advocate.