There are many reasons why homeowners may choose to change their current principal place of residence (PPOR) into an investment property. Perhaps they are looking to upgrade to a larger – or perhaps downsize to a smaller – model, and wish to retain the original property as an investment, or maybe they have been geographically relocated due to work obligations. Regardless of the reason, there are numerous factors that homeowners, and subsequent investors, should be aware of when making the switch, especially in regards to tax.
To start with, let’s clarify exactly what the two main terms are that we are dealing with here. The ‘principal place of residence’ can be defined as being the one place of residence that is, among the one or more places of residence of the person within and outside Australia, the principal place of residence of the person. Put simply, a person can only have one principal place of residence in the whole world.
‘Investment property’is property, whether land or a building, part thereof, or both, which is held by the owner (or by the lessee under a finance lease) to earn rentals or for capital appreciation or both.
The shifting of labels from PPOR to investment property occurs upon the homeowner’s physical relocation to the newly purchased property, that is, the new
PPOR. Once this relocation has occurred and the first property is deemed to be an investment, there are several tax implications that the owner should to be aware of. Such tax issues
include, but are not limited to, potential deductions as well as various possible capital gains tax exemptions that the owner may eligible to claim, that are not able to be claimed on the PPOR.
Perhaps one of the simplest tax deductions that can be claimed is that as soon as the property is legally an investment – that is, it is no longer the taxpayer’s PPOR – any interest that is paid as part of the loan repayments for that property becomes a tax deduction. Note that only the interest, and not the principal repayments, can be deducted at tax time.
Another deduction available to investors is depreciation. Depreciation deductions were changed in 2017 (see here
), but capital costs can be deducted after being calculated at a rate of 2.5% per year in the 40 years following construction. This is available for the construction costs of:
- extensions, such as a garage or patio
- alterations, such as adding an internal wall, kitchen renovations or bathroom makeovers
- structural improvements, such as a gazebo, carport, sealed driveway, retaining wall or fence
For example, if you purchase a two-year-old investment property for $400,000, the deduction that can be claimed annually is $10,000 (2.5% of $400,000) for the remaining 38 years, or the proportion of that period that the property remains owned by that particular taxpayer.
Generally speaking, any capital gain or loss that is incurred as a result of disposing of, or selling, a PPOR is exempt from any capital gains tax (CGT) obligations.
However, there exist certain situations whereby at the time of sale of the property, the owner may be eligible for a partial CGT exemption. The two particular circumstances where the partial exemption is applied are:
- the property was not used as the owner’s main residence for the entire period of ownership (although in some cases specific absences are allowed, this is discussed further below); and
- the property was used for income-producing purposes, while it was the taxpayer’s main residence and if a loan was taken out to purchase the property the taxpayer could have deducted the interest paid on that loan
For the purposes of this particular article we are more concerned with the first instance. The example below demonstrates how the partial CGT exemption can be applied upon the disposal of an investment property that was once a PPOR.
A property was purchased on 1 July 2002 for $500,000. It was the owner’s PPOR until 30 June 2005 when it was then rented out until it was sold for $750,000 on 1 July 2007. The capital gain as a result of the sale was $250,000 and the owner is entitled to a partial tax exemption for the period in which they occupied the property. The exempt amount is calculated using the formula, amount of capital gain x number of years property was owner’s PPOR as a proportion of total years of ownership = amount of capital gain that is exempt.
In this instance the calculation is as follows:
$250,000 x 3yrs = $150,000
As $150,000 of the total capital gain is exempt from tax, the amount of taxable capital gain is $100,000. Additionally, as the property was owned for more than 12 months the owner is entitled to a further 50% discount on the assessable amount, making the total capital gain amount that is assessable for tax purposes $50,000 upon the disposal of this property.
CGT – 6-year rule
As mentioned above, there are provisions that allow for an owner’s temporary absence from the PPOR which do not affect the owner’s eligibility for the full PPOR exemption; this is commonly referred to as the six-year rule.
The six-year rule provides that the property’s owner can be temporarily absent from the PPOR for up to a maximum of six years at a time, without losing the exemption, provided that no other property is treated as the PPOR during that period. The owner can use the property to produce assessable income during that time and reset the six-year period each time they move back.
How it works in real life
A property is owned and occupied by the owner for a period of three years, following which the owner is then posted overseas for work commitments and remains there for four years; during this time the owned property is rented out. The owner returns to the country and occupies their PPOR for a further three years until such time that they are again posted overseas, this time for a period of four years. Upon returning to the country a second time the owner then sells the property.
In this case, there is no CGT payable upon the disposal of this property as the owner was never away from the property for more that six years at a time, and no other property was treated as the PPOR during this period.
There are some definitive factors that must be considered in order for the six-year rule to apply. One of these is that you need to move from your PPOR for a good reason. Some examples of ‘good reasons’ include accepting a new job interstate or overseas, staying with a sick relative long term, or going on an extended holiday.
There are various other financial and tax implications to be considered when transferring a PPOR to an investment property; some of the main ones to be aware of have been explored above. It is important to remember that each individual situation is different and has a range of influencing factors. When considering making any kind of significant financial investment or transfer it is important to seek the professional advice of a lawyer and/or accountant in order to ensure that you make the best possible choices for your situation.
Michael Quinn, director of The Quinn Group, is an experienced lawyer, accountant and educator.