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In the sixth of a series of articles, Malcolm Finney, author of 'Personal Tax Planning: Principles and Practice', looks at the effect of divorce and separation on main residence relief.

Introduction to Divorce or Separation

A married couple who are living together are entitled to one sole or main residence (TCGA 1992 s 222).

This does not apply where:

• the spouses are not living together; or
• following divorce.

In either of these two situations each spouse may possess their own sole or main residence.

Where one spouse is resident in the UK but the other spouse is non-resident they are still treated as living together (assuming that they are not either separated or, of course, divorced) (Gubay v Kington (1983)).

Divorce or Separation - Legal Aspects

Spouses are treated as ‘not living together’ where they are separated in such circumstances that the separation is likely to be permanent. Although normally divorce follows a separation this is not strictly necessary. Spouses may be treated as separated for present purposes even though a decree of judicial separation (granted under MCA 973 s 17) is not in force or has been granted.

Where a decree of judicial separation is in force the will of either spouse is not affected (MCA 1973 s 18) although either spouse cannot succeed to the other’s property on an intestacy.

‘Divorce’ refers to ‘annulment’ or judicial separation’ and the requisite law is contained in MCA 1973 (Part I sets out the law with respect to obtaining a divorce and Part II deals with fiancé and property orders).

Following a petition for divorce, assuming the judge is satisfied that the case for divorce is made out, a ‘decree nisi of divorce’ is granted. Such a decree does not, however, terminate the marriage.

Only when a ‘decree absolute’ is granted is the marriage terminated/dissolved and both spouses are then free to re-marry.

Spouses may try and reach some form of divorce settlement without the need for the intervention of the courts other than to obtain a court order which, in essence, ratifies the agreement already reached. Alternatively, the court may impose a court order as it sees fit in the light of all the relevant circumstances.

However, the CGT (and IHT) implications of transfers of property between spouses (which may be agreed between them) vary according to whether the spouses are separated or divorced (i.e., grant of a decree absolute has been issued) at the time of the transfers. Care thus needs to be exercised if any adverse tax consequences are to be minimised.

Transfers of Property in the Context of Divorce and Separation

Three possible scenarios arise:

• where spouses are married and living together transfers are effected at neither gain nor loss (TCGA 1992 s 58);
• where spouses are separated but not divorced (e.g., the decree nisi may be in force but the decree absolute has not been issued) transfers effected after the end of the tax year of separation are transfers between ‘connected persons’ (TCGA 1992 s 286) and thus are deemed to be made at market value; and
• where spouses are divorced (i.e., the decree absolute is in force) transfers effected are no longer between spouses (or connected persons) but between two independent individuals and actual consideration passing applies (i.e., no market value imputation).

Typically, on a separation/divorce one of the spouses leaves the matrimonial home (i.e., the sole or main residence) whilst the other spouse (often with children) continues to reside in it. If the departing spouse is to transfer his/her interest in the property to the other spouse avoidance of CGT requires that this interest is transferred within 36 months of departing the property (i.e., the last 36 months of ownership qualifies for sole residence treatment in all circumstances).

The recipient spouse (i.e., the spouse continuing to reside in the property) acquires this interest at the date of the transfer at market value (assuming the transfer occurs after the end of the tax year of separation and before the decree absolute); a transfer before the end of the tax year of separation but following separation is effected at no gain/no loss (i.e., recipient spouse acquires the interest at the departing spouse’s original acquisition cost).

Any transfer by the departing spouse after the 36-month period has expired precipitates a CGT charge on his/her part with respect to the capital gain attributable to the excess period.

However, this may not be the case where the conditions of ESC D6 apply.

Extra Statutory Concession D6

Under ESC D6 the departing spouse may treat the time period from the date of departure to the date of the transfer of his/her interest in the property to the other spouse as a period of residence. The effect is therefore to permit the departing spouse to avoid a CGT charge arising on the transfer (even if it occurs after the 36-month period).

ESC D6 requires that:

• the transfer must be part of a financial settlement;
• the spouse remaining in the property must have continued to live in it; and
• the departing spouse must not have elected for some other property to qualify as his main residence for this period.

Where the departing spouse acquires another residence after leaving the matrimonial home in respect of which sole or main residence relief may be available, the departing spouse may either invoke ESC D6 or, alternatively, ignore it and claim main residence relief on his/her newly acquired property.

The choice depends upon the amounts involved for the relevant time period.

Divorce, Tax and the Matrimonial Home

On divorce the matrimonial home is often the couple’s most valuable asset. There are a number of options open to the court with respect to the home; although various options appear to fall in and out of favour with the courts over time.

Two often used options are the so-called ‘Mesher order’ and the ‘Martin order’.

Under a Mesher order the property is settled on trust for one or both spouses in appropriate shares and is to be sold when the youngest child attains, say, 18 or on ceasing full-time education. Historically, it also used to provide for sale if the spouse remaining in the property (typically the wife) died, remarried or co-habited although this is no longer a condition adopted.

For CGT purposes the spouses are treated as disposing of their respective interests in the property to the trust at market values (as at the time of disposal to the trustees, the spouses and the trustees are connected persons) at the date of the order. No CGT charge arises on the spouse remaining in occupation and similarly no such charge arises to the departing spouse (assuming the transfer is effected within 36 months of leaving the property although HMRC appear to accept that ESC D6 may apply assuming, of course, that its conditions are satisfied).

When one of the events specified in the order occurs the trustees are deemed at that date to have sold and re-acquired the property at its then market value in principle precipitating a capital gain subject to CGT (TCGA 1992 s 71; effectively the trust terminates and the trustees henceforth hold the property as bare trustees for the spouses). However, on the deemed disposal by the trustees sole or main residence relief is available to the trustees as one of the beneficiaries (namely, the spouse who remains in the property) occupies the property under the terms of the trust (TCGA 1992 s 225).

As and when the trustees subsequently sell the property any appreciation in the value of the property between the date of termination of the trust and the date of sale is subject to CGT on the part of each spouse as appropriate (the trustees are not subject to charge as they are holding the property as bare trustees for the spouses); for the spouse remaining in the property sole residence relief applies to such gain on her interest but the departing spouse may suffer a CGT charge on such gain on his interest.

A Martin order is similar to a Mesher order. The difference is that the spouse remaining in the property is permitted to do so indefinitely subject to a sale being precipitated if the spouse dies, remarries or cohabits; however, no sale is precipitated due to the children either attaining a certain age or ceasing full-time education.

The CGT consequences are the same as those for the Mesher order.

Other options include an outright transfer from one spouse to the other; the granting of a life interest in the property to one spouse reverting to the other spouse (or possibly the children) on the death of the occupying spouse; or an outright transfer to one spouse but the transferring spouse retaining a right to share in the sale proceeds on the sale of the property on the occurrence of one of a number of specified events (the share of the sale proceeds may be based upon market value of the property at the date of the court order or date of sale; in the latter case some form of indexing linking may also apply).

For the departing spouse the date of the transfer of his/her interest is the date of the order for CGT purposes; thus, a CGT liability is crystallised at this point.

However, any such capital again is normally exempt either because the transfer occurs within 36 months of the departing spouse leaving the property or ESC D6 applies. No allowance is made for CGT purposes due to the deferral of the receipt of any consideration from the sale (TCGA 1992 s 48).