Capital gains tax (CGT) is one of those ubiquitous taxes that will almost always crop up when you sell something, unless the sale is in relation to a revenue asset (eg trading stock or depreciating asset). The same applies to real estate – if you sell a property, and unless you are in the business of buying, developing and selling properties, any gain you make from the sale of the property will likely give rise to CGT except for any specific exemption (eg, the ‘main residence exemption’) that may apply.
Given that CGT is a ‘sleeper tax’ that does not generally become relevant until something is sold, many people do not consider how to minimise CGT at the outset when the property is originally acquired. However, knowing how the CGT rules work may help you minimise your future tax exposure when you eventually sell the property.
How does it work?
The default mechanics of CGT are deceptively simple: if you sell a property and the ‘capital proceeds’ you receive on the sale exceed its ‘cost base’, the difference is a capital gain. If the property is held by an individual or a trust for at least 12 months, the capital gain will be halved by the 50% CGT discount, and the resulting net capital gain is included in the assessable income of the selling entity. On the other hand, if the cost base exceeds the capital proceeds, you will make a capital loss.
However, if the property was originally acquired before 20 September 1985, the property is a ‘pre-CGT asset’ and any capital gain or loss resulting from the sale of the property will be disregarded.
Despite these seemingly simple rules, as with the English language there are exceptions to the rules, which may catch the unsuspecting. To that end, the following tips may be helpful:
1 Turning your main residence into an investment property
Most people could be forgiven for thinking that the cost base of a property will generally be the price they paid for it, including stamp duty and other incidental costs (eg legal costs) on the original purchase and sale of the property. However, there is a somewhat elusive rule which says that, if you originally bought a property as your main residence but you subsequently first started using it to produce income after 20 August 1996, for CGT purposes you will be deemed to have acquired the property when it was first used to produce income at its market value at that time.
In other words, if the property has increased in value in the period from when you originally bought it to when you turned it into an investment property, you are allowed to uplift the cost base to its market value when the property was first used to produce income. An uplifted cost base will then have the effect of reducing the future capital gain on the property. Naturally, you will have the onus of proving the market value of the property adopted to calculate the CGT liability on the future sale of the property, so obtaining a valuation from an independent party may be a worthwhile exercise
2 Temporary absence rule
If you originally buy a property as your main residence and subsequently rent it out, you may choose to continue to treat it as your main residence, so long as you do not treat another property as your main residence.
The length of time you can temporarily be absent from the property without affecting its main residence tax-free status will depend on whether you use the property for income-producing purposes after you have moved out. If the property is not used for income-producing purposes, you are allowed to treat it as your mainresidence indefinitely. Otherwise, you are only allowed to continue to treat it as your main residence for up to six years.
If you do decide to take advantage of this temporary absence rule and continue to treat the property as your main residence, you need to be aware that any new home you buy will be exposed to CGT if it is sold in the future, because you are generally only allowed to have a single tax-free main residence at any one time.
On the other hand, if you choose to treat the new home as your main residence, you may expose yourself to an apportioned CGT when the old home is eventually sold, based on the period of time the property was not covered by the main residence exemption relative to its entire ownership period.
In any event, given that you are not required to notify the ATO at the time you convert your home to an investment property, you may have some ‘benefit of hindsight’ when you eventually sell one of the properties, which is the time when you need to make a decision on which property and for what period(s) you wish to apply the main residence exemption to each property. Sitting down with your tax adviser to work this out may save you a bundle.
3 Non-capital ownership costs
As I mentioned above, for the purpose of calculating the CGT on the sale of a property, the cost base is deducted from the capital proceeds. Generally, the cost base is the purchase price of the property, plus stamp duty and incidental costs on both its original purchase and sale. Capital costs to improve the property (eg structural and the costs of renovations) can also be included.
However, many people are not aware that certain ‘non-capital ownership costs’ may also be included in the cost base, provided the property was originally acquired on or after 21 August 1991.
Consider the scenario in which you turned a main residence into an investment property. Until the property first became available for rent, none of the costs of ownership of the property would have been tax deductible as a tax deduction is only available if the relevant expense has been incurred in the course of producing assessable income or carrying on a business. Therefore, if you sell the property and you have non-capital ownership costs, you are allowed to include certain noncapital ownership costs that were never allowable as a tax deduction into the cost base of your property.
These non-capital ownership costs include interest on monies borrowed to either buy the property or acquire capital improvements to the property; maintaining, repairing, and insuring the property, as well as rates and land taxes incurred on the property. Remember: the higher the cost base, the lower the capital gain, so it may be worth keeping a record of these costs if this applies to you.
4 Combining Tip #1, Tip #2, and Tip #3
Recalling Tip #1 above, if your main residence becomes an investmentproperty for the first time after 20 August 1996, you are deemed to have acquired the property at its market value at the time when it was first put to income-producing use.
Applying this rule to the 50% CGT discount, if you sell the property within 12 months of the changeover time, the 50% CGT discount will no longer apply, even though you have actually owned the property for more than 12 months if you count from the time you originally purchased it to when it is sold. Therefore you need to be careful with the timing of when you sell the property in this situation. Where possible, if you can sell the property after 12 months from the time the property was first put to income-producing use, you could save yourself half the CGT that would otherwise be payable.
Due to the application of the deemed acquisition rule, you also need to be careful about any non-capital ownership costs you wish to include in the cost base of the property. If the property was originally bought before 21 August 1991 but was first used to produce income after 20 August 1996, the cost base can only include non-capital ownership costs that were incurred after the property was first used to produce income. Incorrectly including the non-capital ownership costs incurred before then could give rise to tax penalties.
Further, if the six-year temporary absence rule applies to the property and you have been absent from the property for more than six years, you will need to ensure that you correctly apportion the capital gain so that you are not paying CGT for the period during which the property was covered by the main residence exemption.
5 Deductibility of interest after the property is sold
If you are in the unfortunate circumstance of having insufficient capital proceeds from the sale of your property to pay off the loan on the property, you may be relieved to know that you are generally allowed to keep claiming the interest on the remaining loan, even though you will not be receiving further rental income once the property is sold.
However, to take advantage of this rule, you should ensure that all the sale proceeds are used to pay down the loan (as opposed to keeping some of them for other purposes), and try to pay down the remaining loan as quickly as possible. However, refinancing the loan will not generally cause the interest to become non-deductible. The critical issue here is that, to defend your claim, you need to demonstrate that you are not keeping the loan going for any other purposes.
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