Capital gains tax (CGT) is often an afterthought for property investors because the tax liability is not usually crystallised unless the property they own is sold, transferred, or otherwise disposed.
However, the amount of CGT payable, if any, directly affects the return on investment of an investment property; not to mention that since capital gain is the ultimate reward in property investment for many that makes negative gearing worthwhile, it is important for property investors to understand how CGT may affect their return on investment as part of their overall investment strategy
Q: What makes a property subject to CGT?
Under the tax law, real property (ie land and buildings) is a ‘CGT asset’ that is generally subject to CGT by default, unless a specific exemption applies to disregard any capital gain that has been derived or capital loss that has been incurred. Therefore, just because a property is not producing income (eg a holiday house) does not automatically render it exempt from CGT.
However, if a property is a revenue asset, which can also be a CGT asset, any gain derived on the value increase on the property will be taxed as income. As the tax rules are designed not to double tax income and capital gains, the ‘anti-overlapping provisions’ will apply to ensure that to the extent that the relevant gain is taxed as income, the same gain will not be subject to CGT.
A common example of a revenue asset pertains to property that was bought, developed and resold with the intention of making a profit. The gain derived on the development will wholly be taxed as income, even though the property is technically a CGT asset.
Having said that, for property investors whose intention for acquiring their property is to hold it in return for rental income and long-term capital gain, the property will be a capital asset unless that intention subsequently changes.
Q: When is a property exempt from CGT?
The tax rules contain a special exemption for homes known as the ‘main residence exemption’.
As a general rule, if you buy a home, live in it for some time, then sell it, any capital gain derived on the property is disregarded as the property has been covered by the main residence exemption throughout your ownership of it.
However, any change of use of the property may potentially affect the extent to which the main residence exemption is available. For instance, you may have bought a home to live in but are subsequently required to temporarily leave your home, so you rent out the property during your absence. In these circumstances, the property may no longer be fully covered by the main residence exemption during which you are away but for the ‘temporary absence rule’, which may extend the main residence exemption to cover some or all of the period during your absence.
Another exemption applicable to a property pertains to the death of a person when the property is inherited by their beneficiary. The tax law is generous in these circumstances and does not trigger any CGT even though the ownership of the property has technically changed.
If the property was originally acquired by the deceased before 20 September 1985, the beneficiary will be taken to have acquired the property at its market value on the date of the deceased’s death for future CGT purposes (eg if the beneficiary disposes of the property in future). If the property was originally acquired by the deceased on or after that date, the beneficiary will inherit the deceased’s cost base in respect of the property.
In addition to these rules, there are a number of special exemptions that may apply to disregard any capital gain derived if the beneficiary disposes of the inherited property in the future. For instance, if the property was the main residence of the deceased just before their death and the beneficiary disposes of the property within two years of the deceased’s death, any capital gain derived may be disregarded or reduced, regardless of whether the property has been used by the beneficiary as their home or to produce income within that two-year period.
Q: How many properties can be exempt from CGT?
As a general rule, a person can only ever have a single home that is eligible for the main residence exemption at any particular time.
If you live in more than one residence, you can only receive the exemption for the residence that you mainly use. If the person has a spouse (which includes a de facto partner) and they jointly own two residences that they live in but one of them mainly lives in one residence and the other mainly lives in the other residence, then the couple can either treat one common property as their home that is covered by the main residence exemption for both of them or nominate two different properties as each of their main residences.
If the person and their spouse nominate two different properties as their main residences, then special rules would apply that may reduce each person’s entitlement to the exemption, depending on the extent to which each person owns the relevant property.
For instance, if you and your spouse nominate two different properties as your main residence and you own 50% or less of the property you nominated as your main residence, you will be eligible for a full exemption on your proportionate ownership of the property. However, if you own more than 50% of the property, you will only be entitled to 50% of the exemption for the period during which you and your spouse have a different main residence.
Q: Can the CGT exemption be extended on a property?
As mentioned above, under the temporary absence rule, if you leave your home, you may be able to continue to treat your home as your main residence and retain its tax-free status, even though you might not actually be living in it.
If the property is not income-producing, you may continue to treat it as your main residence for an indefinite period, as long as you do not treat another property you own as your main residence. If you use the property to produce income during your absence (eg you rent it out), you may continue to treat the property as your main residence for up to six years.
If the property is only income-producing on and off (ie it is sometimes available for rent while it is not at other times), any of the non-income producing periods is not counted, as long as the total of the income-producing periods do not exceed six years.
When you return to the property to live as your main residence after a temporary absence, you can essentially ‘restart the clock’ for another six years if you subsequently vacate the property again. However, you will not be able to treat any other property as your main residence for this period. There is nothing in the law to say how long you need to live in the property again as your main residence before you could restart the clock – whether or not you live in the property as your main residence is a question of fact, which takes into account a number of factual circumstances, eg the postal address for all of your personal correspondence.
For completeness, regardless of whether the property has been used for income-producing purposes, there is no requirement that you actually have to move back into the property to qualify for the exemption, eg you could sell the property before the six years are up and still be exempt from CGT on the sale. The key is that you must have lived in the property as your main residence immediately after its purchase. The temporary absence rules will not apply to a period before you use the dwelling as your main residence and you may be exposed to an apportioned CGT to reflect the period during your ownership period when the property was not covered by the main residence exemption.
Q: How is capital gains tax calculated?
To calculate the CGT on the sale of an investment property, the capital gain on the sale will need to be calculated, which is aggregated with other capital gains and reduced by any current year and/or carried forward capital losses to arrive at a ‘net capital gain’. This net capital gain will then be added to the relevant entity’s taxable income that is subject to tax in the ordinary manner. For instance, as an individual selling an investment property, the net capital gain on the sale of the property is added to your taxable income, which is subject to tax at your marginal tax rates.
The capital gain on the sale of a property is generally the capital proceeds (ie the sale price of the property) less the ‘cost base’ of the property. Therefore, the higher the cost base of the property, the lower the net capital gain and therefore CGT associated with the sale.
The cost base of a property includes a number of elements, which include the original purchase price, the incidental costs (eg stamp duty, legal costs, etc) on both the purchase and sale of the property, capital expenditure to improve the property’s value, and costs to preserve or defend your title to the property. If the property was acquired after 20 August 1991, certain other costs (known as ‘third element’ of the cost base) that would ordinarily be revenue in nature but are not eligible to be claimed as a tax deduction may also be included in the cost base, including interest on money you borrowed to acquire the property, costs of maintaining, repairing or insuring the property, rates or land tax, etc.
If the property was acquired on or after 13 May 1997, the cost base of the property will be reduced, however, by the cumulated capital works deductions that have been claimed on any building and/or improvements attached to the land in respect of the property.
For completeness, if you move out of your home where you have always lived as your main residence since its purchase and rent it out (eg you bought a new home), then the market value of the old property at the time it first starts producing income will become the cost base of the property for future CGT purposes if it is sold in the future. Documentation to defend this market value should be obtained in case of potential future enquiries or audit by the tax office.
Q: What is the major concession available to reduce CGT?
As mentioned above, the amount by which the capital proceeds exceed the cost base will be the capital gain. If a property has been owned for at least 12 months before it is sold (usually counted between contract dates) and the entity that owned the property was an individual or a trust, the capital gain will be halved under the 50% CGT discount; if the entity is a complying superannuation fund, the CGT discount is 33.33%. However, if the entity is a company, no CGT discount will be available.
Alternatively, instead of applying the CGT discount, the entity may elect to index the cost base of the property to calculate the capital gain. However, indexation has been ‘frozen’ as at 30 September 1999, so regardless of when the property is actually sold, you may only index its cost base up to that date (the frozen Consumer Price Index on 30 September 1999 is 123.4).
The above attempts to address some of the most frequently asked questions by property investors in a generic manner. As usual, situational differences applicable to your circumstance may alter the tax analysis due to the complexities of the tax law, so specific advice on your individual circumstance should always be obtained from your trusted tax adviser.
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.