Co-habiting is commonplace in today’s society, and provides many financial benefits. But is this the most tax efficient way of living?
In common parlance co-habitees is a term normally used to refer to a man and woman who, whilst not married, are living together as if in fact they were married; this is how the term is used in this article.
It is often assumed that co-habitees are treated for tax purposes in the same manner as the conventional married couple; this, however, is not the case.
There is no tax legislation that specifically deals with co-habitees and hence the tax rules that apply are exactly the same as if, inter alia, two brothers, two sisters or two friends lived together.
Each co-habitee is entitled to a personal allowance (£6,475 for 2010/11 if under age 65) but if either co-habitee has insufficient income to utilise their allowance it cannot be transferred to the other. Similarly, income of one co-habitee cannot be treated as if it is the income of the other. Perhaps the one exception relates to rental income from, for example, a buy to let property.
Tom and Mary live together as husband and wife. Tom is a 50% taxpayer; Mary is a basic rate (20%) taxpayer.
They decide to purchase a buy to let property each contributing equally to the purchase price. However, it makes sense if Mary receives more of the rental income. Tom and Mary can agree that although the property is owned 50/50 the rental income is to be split, say, 80/20 in Mary’s favour.
Capital Gains Tax (CGT)
The same principles apply here. Each co-habitee is liable to CGT on any capital gains he or she makes. Where the annual exempt amount (i.e. the amount of capital gains which can be made CGT free; £10,100 for 2010/11) is unused by one co-habitee it cannot be transferred for use by the other co-habitee.
For married couples transfers between them are CGT exempt; however, this does not apply to transfers between co-habitees. Thus, in the Example, if Tom transfers say half of his interest in the property to Mary, a CGT charge arises on his part on any appreciation in value of that interest which would not arise had they been married.
One advantage for co-habitees, however, is that each may own a sole or main residence in respect of which on sale any capital gain is CGT free; married couples are only entitled to one sole or main residence.
Inheritance Tax (IHT)
For married couples, inter-spouse transfers both on death and in lifetime are IHT exempt. This does not apply to transfers between co-habitees.
This has a number of disadvantages. First, any lifetime gifts from one to the other are subject to IHT if the donor dies within 7 years (unless the nil rate band (NRB) has not been fully utilised; £325,000 for 2010/11). Second, on death, any part of the estate of the deceased co-habitee which passes to the other is subject to IHT (assuming the NRB has been fully utilised). Third, it is not possible for one co-habitee who does not use his/her NRB to transfer the unused element to the other (which is possible for married couples).
Domicile determines the extent of an individual’s exposure to income tax, CGT and IHT [as previously mentioned in the August issue of Tax Insider].
A child’s domicile status is determined at birth by that of his/her father if legitimate. However, a child of co-habitees is illegitimate and thus, his/her domicile status, is determined by the domicile status of the mother.
This may be very important where the mother is herself non-UK domiciled (very broadly and simplistically, a foreign national).
If co-habitees intend to marry, transfers from one to the other should be deferred until after marriage.
By Malcolm Finney
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