Hidden capital gains tax traps you may not know about

For many people, owning their own home is still very much the great Australian dream, despite the well-publicised home affordability issue that seems to be consuming everyone at the moment. 

Broadly speaking, if you buy a home and subsequently sell it for a capital gain, the gain is generally treated as tax-free under the ‘main residence exemption’. 

In other words, the current tax rules generally respect the community’s sentiment that the family home has a special place in everyone’s heart and should therefore stay outside the tax net, even though the capital gains tax (CGT) rules normally apply to both income-producing and private assets. 

However, there are a number of instances, sometimes to many people’s rude surprise, where a property bought as a family home may be subject to CGT. While some of these situations cannot be avoided, others may certainly be managed and planned to avoid nasty future surprises. 

Case #1: Adjacent land

While this may not be common in inner-city areas, homes that incorporate significant land content may be partially subject to CGT if they are sold. 

Under the tax law, any capital gain attributable to the land that is immediately under the physical building of your home and its adjacent land can be tax-free up to two hectares, including the land on which the physical building of your home is situated; in other words, any adjacent land that exceeds two hectares will not be covered by the main residence exemption. 

Therefore, if the entire property is sold in the future, an apportionment of the capital proceeds and cost base of the excess land will be necessary 
to calculate its apportioned capital gain, which will be subject to CGT. An independent property valuation may provide a basis for these apportionment calculations.

Interestingly, the tax office generally allows you to determine which portion of the adjacent land is counted towards the two hectares that are sheltered from CGT by the main residence exemption. Also, any adjacent structure to your home (such as a garage, storage shed, etc) that is used primarily for private or domestic purposes in association with your home is counted as part of your physical home in calculating the two-hectare threshold, provided that the adjacent structure is sold together with your home. 

Case #2: Multiple homes

It is not uncommon for some people to own multiple properties that are used for private purposes. The most common examples are beach houses that are used by people as their holiday homes. Less commonly but not entirely unheard of are situations in which some people legitimately own multiple properties as their permanent homes. For instance, a person may live in a home near the city for half a year for work, but live in a rural property for the remainder of the year to attend to their hobby farm. 

Generally speaking, you can only claim one property as your tax-free main residence at any one time. Therefore, if you own multiple homes, you may apply the ‘temporary absence rule’ on one of those properties so that one of the properties will be covered by the main residence exemption while the other property will be subject to CGT.

If you have a spouse and each of you has a different main residence in a given period, you must either:

●    Choose one of the properties as the main residence of both of you for the period; or
●    Nominate different properties as your main residences for the period. 

If you choose to nominate different properties as your main residences, you will be required to split the main residence exemption as follows:

●    If you do not own more than 50% of the property you choose as your main residence, the property is taken to have been your main residence during that entire period; or
●     If you own more than 50% of the property you choose as your main residence, the property to taken to have been your main residence for only half of that period.

The same applies to the property that your spouse nominates as their main residence.

Take the example where you and your spouse own an inner-city home on an equal basis; the two of you also own a beach house, which is owned 40% by you and 60% by your spouse. You live mainly in the inner-city home and your spouse lives mainly in the beach house.

If you nominate the inner-city home to be your main residence while your spouse nominates the beach house as their main residence, the inner-city home will be treated as your tax-free main residence throughout the period during which you and your spouse own the different properties as your main residences(because you own 50% or less of the inner-city home). 

However, the beach house will only be treated as your spouse’s main residence for half of the period during which you and your spouse own the different properties as your main residences(because the spouse owns more than 50% of the holiday house).

In other words, one way or another, CGT will apply to the extent that the relevant property is not covered by the main residence exemption under the operation of these rules.

Case #3: Income-producing use

Another scenario which may turn an otherwise tax-free home into a taxable CGT asset is when the home has been used for income-producing purposes and, if you have incurred interest expenses on money borrowed to buy the property, you could have been entitled to claim a tax deduction on some or all of the interest expenses, even if the property is concurrently used as a home while it is producing income. 

A common example would be a property which is partially used as a home and partially used as a ‘principal place of business’ – in which case any capital gain derived on the sale of the property will attract apportioned CGT to the extent of the income-producing use.  

It should be noted that a home office is different from a principal place of business. The former generally relates to an area of your home that you use to undertake work activities but there is a principal place of business associated with those activities elsewhere; the latter refers to the situation where a business is operated exclusively or mainly from your home for business activities.

For the purposes of the main residence exemption, the interest expense incurred on a loan to purchase the property where one of the rooms is used as a home office, if such a loan was drawn down, would not generally be tax deductible. Therefore, using a part of your home as a home office will not generally expose that part of the property to CGT. 

Case #4: Demolished homes

Perhaps one of the trickier scenarios which may catch someone offguard is when an individual demolishes their home and subsequently sells off the land. One may have assumed that the main residence exemption must cover at least the period during which there was a building on the land, which was used as a main residence. Surprisingly, that is not how the law works – the main residence exemption will only apply if the land is sold with a physical home on the land. If the land is sold as vacant land, the main residence exemption will not be applicable at all. An exception to this rule is where the building is accidentally destroyed and the land is sold without erecting another dwelling. 

By way of a real-life example, which happened to one of my clients, she and her husband bought an acreage of about two hectares as their home many years ago and found themselves in a marriage breakdown. As part of their matrimonial property division, they jointly decided to demolish their home and undertake minimal work to subdivide the land for sale and split the proceeds. Despite the fact that they had lived on the property for more than 15 years before the demolition, the sale of the subdivided land did not qualify for any main residence exemption, which gave rise to a less than satisfactory tax outcome for them.

Therefore, if you are thinking about demolishing your home and selling the vacant land, you may wish to think twice. 

Case #5: Extended temporary absence

Under the ‘temporary absence rule’, if you own an existing home and buy a new home, you may choose to continue to treat the existing property as your main residence, provided that you do not treat the new property (or any other property for that matter) as your tax-free main residence. 

If you rent out the existing property, you can continue to treat the property as your main residence for up to six years. If you do not rent out the property at all, it can continue to be your main residence indefinitely. Further, if you move back into the property just before the six years expire, live there as your home, and vacate it again, the temporary absence rule effectively allows you to ‘stop and reset the clock’ and you are entitled to another six years if you rent the property out again.

A CGT exposure may arise if you rent out the property for more than six years, sell the property, and make a capital gain, in which case you may be required to pay apportioned CGT on the property. Normally, the apportioned capital gain will be calculated with reference to the period of time during which the property is not covered by the main residence exemption as a proportion of the entire time you have owned the property.

However, the acquisition time and cost base of the property may be modifi ed if the following conditions are satisfied:

●    You would only have been entitled to claim a partial main residence exemption on the property because it was used to produce income during your ownership period on or after 20 August 1996; and
●    You would have been entitled to a full main residence exemption on the property if the property was sold just before it fi rst started producing income.

If these conditions are satisfied, you are deemed to have acquired the property at its market value when the property first started producing income. To defend the market value that will be used to calculate the capital gain, you should consider obtaining a valuation to determine the value of the property at the time when it was first used to produce income. 

Case #6: Non-individual owner

As obvious as this may seem, if you own your home through an entity(eg a company or a trust), rather than in your own name as an individual, the main residence exemption will not be applicable. 

There may well be a good reason for you to own your home through another entity. For instance, you may have been advised to have your home owned by a discretionary trust under your control for asset protection. However, making such a choice will also compromise the tax-free status of the property, which is why you should only consider implementing such an arrangement if there is a compelling reason for you to do so that outweighs the tax benefit foregone due to the main residence exemption.

Eddie Chung is Partner, tax & advisory, property & construction, at BDO (QLD) Pty.

Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. The article is provided for general information only and the author and BDO (QLD) Pty Ltd are not engaged to render professional advice or services through this article. The author and BDO (QLD) Pty Ltd expressly disclaim all and any liability and responsibility to any person in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this article.

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