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tax matters

Earlier this year, British resident Jane Mulcahy attempted to sue her divorce lawyers. Why? Because they didn't explain to her that finalizing her divorce proceedings would result in her marriage coming to an end. She argued that they should have taken into account her belief in the sanctity of marriage and should have recommended a judicial separation instead. The court rejected her claims.

If you happen to be going through a divorce, there are a couple of important things to keep in mind. First, finalizing your divorce will mean that your marriage will officially end. Second, divorce can complicate your income tax situation – particularly as it relates to your family home. Let me explain.

The rules

Our tax law provides a principal residence exemption (PRE) which can shelter all or part of a capital gain on the sale of your home. The catch is that each family unit (you, your spouse and any unmarried children under 18) will be allowed to designate just one property as your principal residence for each calendar year.

Suppose, for example, you own both a city home and cottage. For simplicity, let's assume you purchased both properties in the year 2000. If you were to sell, say, the cottage this year, you could designate the cottage as your principal residence for the years 2000 to 2014 if you wanted. This means you would be sheltering the cottage for all of the years it has been owned, so that 100 per cent of any capital gain would be sheltered from tax. This also means that those 14 years are spoken for and you won't be able to designate the city home as your principal residence any of those same years.

If, instead, you were to designate the cottage for, say, seven of the 14 years, then part of the capital gain on the cottage would be sheltered. This would allow you to use the other seven years for the city home and shelter part of its capital gain as well. But, you can't fully shelter both properties from tax because you can only designate one property as your principal residence for each calendar year. (By the way, the rules are a little more complex than this, since our law does allow you to own two properties that overlap by one year, and still fully shelter each property from tax.)

When you divorce, each former spouse will be entitled to his or her own PRE, but not for the years in which you were married. Let me explain by way of a story.

The story

John and Jan divorced in 2010. During their marriage the couple owned a cottage (purchased in 2000) and a city home (purchased in 1994). As part of their divorce, they sold the cottage, and Jan kept the city home. They sold the cottage tax-free by using the PRE available to them. That is, they designated the cottage as their principal residence for the years 2000 through 2010, and paid no tax.

Now, four years later, Jan wants to sell the city home that she owns. She'll be able to designate the home as her principal residence for the years 1994 through 1999 (because she and John did not use up those years when designating the cottage sold earlier), and for the years 2011 through 2014 (because she is entitled to her own PRE after their divorce), for a total of 10 years. But the home has been owned for a total of 20 years. The result? Years after her divorce, a good portion of Jan's capital gain on the home will be taxable. She may not have expected that.

What if John and Jan had not sold the cottage when they divorced? Rather, what if they had each kept one of the properties? In that case, the first person to sell their property might "win the race" to claim those years while they were married and designate their own property as a principal residence for those married years. This suggests that any good separation or divorce agreement should clarify how the PRE will be claimed upon a subsequent sale of a particular property.

As a side note, you'll each be entitled to your own PRE after you're living apart only where you have a written separation agreement or a court order in place. Similarly, if you each own a property on the day you get married, you may want a marriage contract that details who will be entitled to the PRE for years prior to a divorce.

Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books.

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