How the matrimonial home is taxed in the US and UK during a divorce

We explore how the matrimonial home is taxed in the US and UK, and the provisions specific to divorce proceedings.

In brief

• The US and UK have their own tax laws governing the taxation of the matrimonial home on divorce.
  
• Tax could apply in each jurisdiction on a sale or transfer.
• There are additional considerations for US tax purposes, in connection to transfers involving a non-US spouse.

The matrimonial home is, often, the most significant asset under consideration during divorce proceedings. The differing UK and US tax regimes — coupled with a particular set of facts — means that some in-depth analysis and planning is crucial.

A key factor from a US standpoint will be the US status of the couple getting divorced. The options for two US persons getting divorced are different than those available in proceedings involving a non-resident alien spouse. An equally important factor in the UK may be timing, as the years immediately following the ‘year of separation’ offer up options that are quickly removed beyond three years.  

We will set out some of the basic concepts that arise in a UK-US cross-border divorce — when the matrimonial home is under consideration. As will be seen, it is possible that the timing of taxation in each jurisdiction could be different and give rise to anomalous financial outcomes.

How UK taxation views the sale of the principal residence during a divorce

Under the private residence relief provisions, individuals are entitled to full tax relief on any gain, following the disposal of their dwelling home. To qualify for full relief, the home must be the individual’s main residence throughout the period of ownership and any periods of absence from the property must be limited to the specific exceptions.

Generally, an individual can only ever have one home that qualifies as their principal private residence at any time — except for the final ‘nine-months deemed ownership’ rule. Nowadays, it is not uncommon for individuals to possess more than one residence. In these circumstances, unless affirmative action is taken by the individual, HM Revenue & Customs will establish which property qualifies for relief on the basis of facts and circumstances. However, an individual can make an election to nominate a specific residence as their main home for relief purposes and such an election must be made within two years of first possessing the second home. A married couple living together can only ever have one qualifying residence between them.

The chargeable gain is calculated by multiplying the gain by the period of occupation over the period of ownership.

Section 58 of the Taxation of Chargeable Gains Act 1992 (TCGA) allows for assets to transfer between spouses living together as no gain-no loss transactions. When there is a divorce or formal separation involved, these provisions cease to apply after the end of the third tax year following the date the couple become permanently separated — and transfers taking place beyond this will be subject to the UK capital gains tax unless the assets are subject to a formal court ordered divorce agreement where no such time limit exists.

‘Permanently separated’ is either a result of a court order or, otherwise, a question of facts and circumstances.

Imagine a set of circumstances whereby a couple permanently separates when one party leaves the matrimonial home. The non-occupying spouse then transfers their part ownership to the occupying spouse more than three years after the year of separation. Notwithstanding any partial relief that may be available for actual occupation and the nine-months deemed ownership provision, the transfer would be taxable.

However, if this is part of a formal court order then there is no time limit imposed on the ability to treat the transfer as being on a no gain no loss basis. Equally, if the departing spouse leaves the matrimonial home but retains an interest in the property, they will have the option to claim principal private residence relief when it is sold to a third party if this forms part of a formal order in the divorce, and the other spouse continued to reside in the property as their main residence until it were sold, and the departing spouse has not given notice to elect another property as their main residence.

Furthermore, if an individual has transferred their interest in the former matrimonial home to their ex-spouse, and under the terms of a deferred sale agreement or order of court they are entitled to receive a percentage of the proceeds when that home is eventually sold, the individual is able to apply the same tax treatment to those proceeds when received that applied when they transferred their original interest in the home to their ex-spouse, i.e., claim principal private residence relief on those proceeds. 

Since 27 October 2021, all disposals or transfers of UK property must be reported to HM Revenue & Customs within 60 days of the transaction and any resulting tax settled at that time. If the transfer of a UK property interest is a part of divorce proceedings, it is the earlier of the dates on which a formal agreement is signed that is approved by a court, or otherwise, the date on which the title deeds are transferred and the land registry is updated.

How US taxation views the sale of the principal residence during a divorce

In contrast to the UK, the US does not allow for an unlimited exclusion from tax on the sale of a primary residence. Provided certain conditions are met, an individual is entitled to exclude up to US$250,000 of gain from taxation. Joint filers can exclude up to US$500,000, provided at least one of them meets the requirements.

For US tax purposes, all such transactions — irrespective of the situs of the property — will have to be converted into US dollars. Therefore, depending upon the relevant exchange rate fluctuations between the original acquisition and the date of sale, it is not uncommon to have a loss in local currency, but a gain when converted into US dollars.

The US provisions, taxing a deemed — or ‘phantom’ — foreign exchange rate gain on the repayment of a foreign currency mortgage, are connected to this. In very simple terms, a foreign mortgage exchange rate gain arises when an individual repays a foreign mortgage at a lower US dollar figure, when comparing the exchange rate on the original loan date with the rate on repayment. These provisions cover instances of refinancing and capital repayments. They are not limited to the sale of a property. Interestingly, the provisions do not appear to enforce recognition of income in instances of a property share being transferred to a spouse during divorce proceedings, providing the debt continues to exist. Any such gains are taxable at ordinary income tax rates and cannot be offset by other capital losses. Conversely, a loss on repayment of the mortgage cannot be used to offset other income or gains.

If the transfer of assets in a divorce is between two US spouses, section 1041 of the Internal Revenue Code (IRC) states that the transfer of property incident to divorce shall occur with no gain or loss being recognised for US tax purposes. Although there is no realisation of tax on transfer, it is important to factor in any financial agreement and latent US taxes on the property, as the transferee spouse takes over the original cost on the basis of the property. Any future gains will include appreciation earned while the property was jointly owned.

As stated above, section 1041 allows for the transfer of assets to a US citizen or US resident recipient spouse without gain or loss recognition. However, there are further considerations where a US spouse is transferring assets to a non-US spouse, as section 1041 is disapplied. It is possible for a non-US spouse to make an election to be treated as a resident of the US for the calendar year in which the transfer occurs and benefit from this provision. The election is provided for in IRC section 6013(g) and the requirements of the election are rather burdensome — not least because the parties must still be legally married at the end of the calendar year, file a joint tax return together and the non-resident alien spouse will expose their worldwide income to US tax. The tax liability on that return will be a joint and several liability.

Furthermore, there are special provisions known as the Federal Investment in Real Property Tax Act (FIRPTA) rules that apply to the disposal of any US situs property by a non-US person, which could include a divorce situation. Subject to certain exceptions, there is an obligation to withhold tax from the amount realised — even where no cash is actually changing hands — regardless of whether there is a capital gain or loss on the transaction. It is possible to apply to the Internal Revenue Service (IRS) in advance of the transaction to apply a reduced withholding. However, the timeframe for doing so is restrictive.

This article has been updated as of the 23 August 2023.