Tax Q&A: Increase in CGT Liability

2/08/2018

Have you got tax queries regarding your property investments and wealth creation strategies? Our experts are on hand to answer them.

Email your question to: editor.yipmag@keymedia.com.au

Q: I bought an investment property in 1999 for $184,000, and in my own name for tax purposes. Over the period 1999 to 2017, it has appreciated considerably based primarily on appreciating land value. 

The house is well presented and basic, but the property is now worth around $1.1m. The capital gain to date is around $916k. 

We are now retired and contemplating selling our current permanent residence in the city, investing around $450,000 of the sale funds in developing the investment property as our new residence out of the city. This process will involve paying out the remaining mortgage on the investment property, demolishing the existing building, and building a new one, which will be our new and only place of residence. 

Given that we will not be selling the investment property and will be residing permanently in the new building from around May 2019, does the capital gain exposure continue? Is there any mechanism to ‘rule off’ the ongoing capital gains tax exposure from the point of occupancy of the new building? 

We are not comfortable with the thought of our investment in major development of the property being subject to a further increase in CGT liability and are interested in what steps should be taken to prevent this.

- Regards, John

A: You are correct – the general principle is that capital gains tax (CGT) is only crystallised when you sell a CGT asset. Practically, what this means is that when you sell your current home, provided that the property has always been your main residence from the time it was acquired, then any capital gain derived on the sale of this property should be completely disregarded for CGT purposes. 

In relation to your investment property, when you turn it into your home, the main residence exemption will start applying, but it will never be completely free of CGT. If and when this property is sold in the future, you will still be required to calculate the capital gain derived on the sale, which is generally the amount by which the sale price exceeds the cost base of the property (including the development costs you intend to incur to improve the property before you move in). 

The capital gain will then be apportioned for the period from when the property was acquired to when it was turned into your main residence as a proportion of your entire ownership period of the property, and you will be liable for CGT on the apportioned capital gain. The only obvious way to avoid this outcome is for you to transfer the property to your spouse who will also live in the property. 

However, you will be required to pay CGT on the capital gain on the property upon the transfer, based on its market value, ie the maximum CGT will be about $916k x 50% CGT discount x 47% = $215k. Stamp duty may also be payable on the transfer. 

Given these liabilities, this is probably not a palatable option, but it does mean that any capital gain derived by your spouse from the future sale of the property will be disregarded under the main residence exemption. In other words, you would only pay CGT on the capital gain on the property to date, but any future capital gain on the property would effectively be quarantined from future CGT, as long as your spouse continues to use the property as their main residence until it is sold.

Eddie Chung

is partner, Tax & Advisory,

at BDO