Questions on capital gains tax on investment property were among the top five queries to financial advisers during this month’s Financial Planning Week, the Financial Planning Association says.
Australians’ love of residential property and the favourable tax treatment of investments in real estate mean capital gains tax is on many people’s radars. People are happy to reduce tax now through strategies such as negative gearing but eventually there will be a capital gain and there will be tax to pay.
Capital gains tax (CGT) can be confusing, particularly if the property was purchased before September 21, 1999 when the rules were simplified.
There are variations in the way the tax is applied depending on the situation. For example, CGT paid on investments held inside superannuation is different from CGT paid on assets held by an individual.
It’s also tied with timing. How long you hold an asset determines how much you pay.
A common misconception about CGT is that it is charged at a flat rate. That’s not the case, said Stephan.
The amount paid depends on your marginal tax rate and that depends on the income you generate.
This means it can be tax effective to time the disposal of an asset so that the sale goes through in a year when the person’s taxable income will be lower.
Sometimes people like to wait until they are getting towards retirements and start taking an income stream from their private pension so they don’t have to pay any income tax. Then their capital gain is assessable at a lower tax rate.
CGT was introduced in 1985, so the sale proceeds of properties that were bought before then are not subject to the tax.
The CGT discount was introduced on 21 September, 1999. This is a 50% discount that applies to the capital gain made on assets bought since that date if they have been held for more than one year, Stephan explained.
Most people understand there is no CGT to pay on the sale of the family home, but many people are confused by the special rules that apply to other properties, such as an inherited home.
You don’t have to pay CGT on inherited property unless you sell it. The cost base might change and not be the purchase price but you don’t pay CGT until the property is sold.
Different rules apply when people turn their home into a rental property or move into a property that was formerly an investment. Stephan warns that some mortgages do not allow the property to be converted into an investment. For simplicity, some people like to sell up and buy another similar property rather than converting the property’s use.
There are no death duties in Australia and a main residence property acquired from a deceased estate is generally not subject to CGT. However there are some important rules to consider to ensure the CGT exempt status is not lost.
Capital gains tax was introduced on September 20, 1985. Nussbaum says that if the deceased person acquired the main residence on or before September 19, 1985, the following rules apply:
The property is CGT exempt if it is sold within two years of deceased’s death.
It is still CGT exempt if sold after two years, providing the following tests are met:
The property was not used to produce income (rented out)
It was the main residence of the person inheriting the property, for example the deceased’s spouse or an individual having a right of occupancy the property under the will.
If the deceased person bought their main residence after September 19, 1985, stricter tests apply to determine whether gains on the sale of the property will be subject to CGT.
All conditions noted above must be satisfied. In addition, the property must have been the deceased person’s main residence just before their death and not used to produce assessable income at that time.
Investment properties of the deceased
Generally, no CGT is payable on the transfer of a property to a beneficiary under a will. CGT will be applicable when the property is eventually sold by the beneficiary. The cost base is calculated as follows:
For pre-CGT investments properties the cost base is calculated based on the market value of the property at the deceased date of death.
For post-CGT investment properties the cost base is calculated based on the deceased’s original cost.
The 50% CGT discount also applies to the sale of inherited properties that have been held for more than 12 months.
The rules on when and how much tax applies are not straightforward, particularly when the investment property starts out as the owner’s primary residence, or becomes the owner’s home after having been rented out for a period of time.
The fundamental principal is that a taxpayer’s main residence is exempt from CGT and that a taxpayer can only have one main residence. Commonly, circumstances can change, especially when the main residence is also used for income producing purposes for certain periods of ownership. Such circumstances include absences from the property and renting out the property for the first time.
Nussbaum prepared the following case study examples for Property Observer to illustrate the CGT outcomes in various situations. Each person’s circumstances are different and you should seek professional tax advice if you have questions on how CGT applies to your situation.
Primary residence becomes an investment property
Absences & the “Six Year Rule”
The main residence home is rented out as the taxpayer is transferred to another city/overseas or decides to move to rented accommodation and keep the existing home.
Home therefore stops being a “main residence”.
The “Six Year Rule” allows the taxpayer to continue to treat the home as their main residence for a maximum period of six years.
If the taxpayer moves back into the property after having rented it out for some time and re-establishes it as the main residence, a further period of six years starts to run if the property is rented again in the future.
If the “Six Year Rule” is breached, as the property is rented for more than six years, then a partial exemption is applicable.
In addition to the “Six Year Rule”, there is also a special rule for properties which first become income producing after August 20, 1996.
The Special Rule relates to determining the cost base of the property.
The property is assumed for tax purposes to have been acquired at its market value when it was first rented out, rather than the actual purchase price.
Example 1: Dwelling first used to produce income – “Six Year Rule”
On July 1, 1994 Bev paid $250,000 for a house that she used as her main residence until July 1, 2007, at which time its market value was $350,000.
If Bev then rented the house until she sold it before July 1, 2013, she would still be able to claim a full CGT exemption by relying on the six-year extended exemption. She would not have to pay CGT on the sale proceeds.
Example 2: Dwelling first used to produce income
Following on from Example 1, if Bev continued to rent the house before selling it for $700,000 on July 1, 2014 (seven years after its first income use), she could only claim a partial exemption for CGT.
In that case, the market value of the house at the time of its first income use ($350,000 on July 1, 2007) is used to determine the capital gain because the property first became income-producing after August 8, 1996.
The capital gain in this case is $350,000 ($700,000 − $350,000 = $350,000). The taxable capital gain would be worked out (ignoring leap years) as follows:
365 days (non-main residence days)
Since Bev has held the property for more than 12 months, a 50% CGT discount would apply. She would have to pay CGT at her marginal tax rate on $25,000 (ie 50% of the $50,000 capital gain).
Investment property becomes a main residence
Only a partial main residence exemption is available if a property is initially rented out as an investment and then becomes the taxpayer’s main residence for part of the ownership period. If the residence is used as a rental property initially, the overall capital gain on eventual disposal is reduced via a pro rata apportionment by reference to the period the taxpayer used the property as their main residence, as explained in Example 3.
Example 3: Former investment property- now main residence
Lisa acquired a dwelling on October 19, 2008 which she let out to tenants until October 21, 2011. From that date she used the dwelling as her main residence. Lisa eventually sold the dwelling on September 7, 2013 and made a capital gain of $40,000, calculated without regard to the CGT exemption provisions. The capital gain is reduced pro rata by reference to the period Lisa used the dwelling as her main residence. The reduced capital gain is:
1,098 (number of days from October 19, 2008 to October 21, 2011)
As Lisa has owned the property for more than 12 months, she would be entitled to the CGT discount and would have to pay tax on $12,302.50 (50% of $24,605).