Capital gains tax, or CGT, is one of the most popular topics for Your Investment Property readers, and also one of the most widely misunderstood concepts. WSC Group director David Shaw explains the most common traps to avoid
One of the most important CGT issues you need to be aware of is that a capital gain is always generated on the date of exchange. Therefore, a property owner should take this into consideration when selling so that a capital gain does not fall into a year when they may not need it because they have significant other assessable income. The following areas are equally important and worth noting:
1. Reduction of the cost base of the assets for the amount of depreciation claimed
The CGT legislation allows for the depreciation that is claimed over the life of the property to be deducted from the cost base of the asset when calculating the capital gain. The cost base is the purchase price plus or minus additional capital expenditure or depreciation claimed. For properties built after March 1997 there is legislation that specifically deducted from the cost base of the asset. WSC Group reviews work performed by other accountants where investment properties have been sold, and the mistake regularly identified is that the purchase price of the property includes the actual purchase price plus legal costs and stamp duty, with no reduction of the cost base due to depreciation when making the CGT calculation. Property investors need to be aware of this, as the longer the property is owned the larger the mistakes that can be made.
2. Apportioning land and building value
In the event of a sale, not only must the depreciation be adjusted but the taxpayer (property owner) is required to commission a valuation to work out the land and building components of the sale. As the building content of the property is often depreciated beyond its market value, property owners could have a situation in which the written down value of the building is less than its market value. This portion of the capital gain is not on the capital account and therefore becomes fully assessable. The capital gain on the land is still subject to the 50% discount but may not form the largest portion of the gain.
3. Moving into the property after purchase
It is important for a purchaser to move into their principal place of residence (PPOR) as soon as possible after a purchase, in order to qualify for the CGT exemption on a PPOR. If there is a current tenant at the time of purchase, it may be better to release the tenant from the lease prior to settlement. There have been court decisions in which the owner of a property has been liable for CGT on a property that was rented for only a few weeks prior to the owners moving in, because the court declared that they did not move into the property as soon as practical after settlement of the property. In fact, the taxpayer would have to apportion the capital gain in this circumstance on the days the property was a PPOR and the days the property was not a PPOR
4. Six-year absence rule
This rule can only be exercised when the taxpayer can demonstrate that the property was their PPOR. Property owners can use this method if they qualify, which allows owners to rent their property out for six years with no CGT consequences.
If the property is sold within that six-year period and the owner has not elected another PPOR during this time, they can exercise this exemption. In fact, if a taxpayer moves back into the property within that six-year period, then the six-year period can be restarted if they move back out again at a later date; therefore, living in the property initially may produce a vastly superior result in the event of a capital gain.
5. Market value rule
The market value method can only be used if property owners (the taxpayer) can demonstrate that the property was initially a PPOR. This method allows the owner to value their PPOR when the property ceases to be their PPOR, and this forms the cost base of the asset rather than the cost base being based on the initial purchase price. This rule also can be applied when the property is sold, if both new and old PPORs are involved. There is an opportunity to defer capital gains to a future point in time if the old PPOR is elected as the main residence. Although this will result in more CGT to pay once the new PPOR is sold, that could be many years down the track.
6. Daily apportionment method
If a taxpayer does not live in the property initially, there will be no entitlement to use the six-year absence rule or the market rule. Property owners will, however, be entitled to use the daily apportionment rule, which will entitle them to apportion a capital gain based on the number of days the property was a PPOR and the number of days the property was generating an income. For example, if a property was only a PPOR for half of the ownership period, this will entitle the taxpayer to reduce the capital gain by 50% before any additional discounts are applied.
7. Two-hectare rule
The two-hectare rule allows a taxpayer to have their entire plot of land covered by a PPOR exemption, but be aware that if the land a PPOR is contracted on is more than two hectares, then the whole property will not be subject to a CGT PPOR exemption. The portion of the land value over two hectares will need to be excluded from the PPOR exemption in the event of a sale. The portion of land between the house and the first two hectares will be exempt from CGT. For example, on a four-hectare lot a capital gain of up to 50% may be taxable. The portion of the gain relating to the two hectares with the house on it can be deducted from the capital gain, and then the 50% discount can still be applied if the asset was held for more than 12 months.
8. Part usage rules
Taxpayers often overlook the fact that if they run a business from their property, the whole property will not be covered by the PPOR exemption. They can, however, if eligible (this is an additional area outside the scope of this article) utilise the CGT and small business exemptions to reduce the capital gain, so not all is lost.
91. Adding costs not deducted to the cost base of the asset
Taxpayers should note that if deductions are not claimed either in part or at all, these can be added on to the capital cost of the asset in calculating a future capital gain. Therefore it is important that all relevant documentation is kept so that the cost base of the asset can be easily calculated. Examples of such costs include council rates, water rates and insurance policies.
RENOVATION OF PROPERTIES
10. A profit-making scheme is not always capital
Often property owners (taxpayers) have the mistaken belief that if they purchase a property, renovate this property and then hold the property for just over a year, any sale will then be on the capital account and the taxpayer will be entitled to a 50% discount. The ATO, however, views these transactions very differently as they look at the intention of the transaction. That is, if the property was purchased with the intention of selling, the ATO will be of the view that when this property is sold the gain on sale will be on the revenue account and hence be fully assessable in the taxpayer’s income. To clarify, the taxpayer will not be entitled to the 50% CGT discount; however, they will only be assessed on the profit when the property settles as opposed to on the exchange date, which would apply in the event of a capital gain. Taxpayers who are also builders employed in the building industry, or who have a history of regular transactions in the development or refurbishment of properties, may be less likely to qualify for having the transaction on the capital account. The ATO has the benefit of history and access to the property sale records, so if you are in a risk category, get the right advice to property sale records, so if you are in a risk category, get the right advice to make sure the property transaction is structured on the capital account.
PROPERTIES USED IN THE FAMILY BUSINESS
11. Extra CGT benefits
Since the CGT small business exemptions were introduced in 1999, properties used in a taxpayer’s business have qualified for further concessions in addition to the 50% CGT discount. The taxpayer (property owner) may be entitled to an additional 50% discount on the remaining capital gain (active asset discount), resulting effectively in a 75% discount. The remaining capital gain is also eligible for the retirement exemption (lifetime limit of $500,000) allowing the capital gain to be deposited into a superannuation if the taxpayer is over 55. Afterwards the taxpayer can receive this portion of the CGT free.
There may also be an opportunity to roll over the last 25% of the capital gain into another business, providing this is done within two years of the capital gain being incurred. Be careful, however, to get the correct advice as to the eligibility of the active asset discount, as the property must have been used in the business for at least half of the ownership period, or at least 7.5 years if the property has been owned for more than 15 years in total. These exemptions are generous, but compliance is strict, so seek professional advice when applying for these discounts.
INHERITANCE OF PROPERTIES
12. Issues with the family home as opposed to the investment property
Property owners should be aware of the history of the property inherited, as the tax consequences in the event of a sale could have a huge impact on future finances. A PPOR or a pre-CGT property(purchased before September 1985) will be inherited at market value as at the date of death, and family members have two years from the date of death to sell the property with no CGT consequences. With an investment property, it is an entirely different story. The investment property is inherited by the beneficiaries at the same cost base as when the deceased purchased the property. If the property has been depreciated over many years, the cost base could be very low, and hence a huge capital gain could accrue in the event of a sale, even if the sale is between family members as a full or partial sale.
is the CEO of WSC Group: Certified Practising Accountants and Business Advisors, and was voted Property Tax Specialist of the Year in the Your Investment Property
2013 Readers Choice Awards (as well as runner up in 2012, 2014 & 2015).