There has been a fair bit of doomsday commentary in the press about the residential housing bubble in Australia lately. Without commenting on the credibility of these reports, if you’re thinking of selling your investment property this article will provide you with a number of tax tips to help you determine and report the capital gains tax (CGT) consequences correctly.
Capital gains tax
Provided you did not buy your investment property for the main intention of selling it at a profit, and you have not changed that intention during your ownership of the property, any gain you make from the sale of the property will be treated as a capital gain, rather than income. This is an important distinction because income is usually fully taxable, while a capital gain may be eligible for the CGT discount if the property is held by an eligible entity and has been held for at least 12 months before it is sold. The discount could be as high as 50% if the property is held in the name of an individual or a trust.
To calculate the capital gain on the sale of an investment property, the basic formula is as follows:
Capital gain = Capital proceeds – Cost base
While this may seem reasonably simple, you might think again after you’ve read the tax tips in this article.
The capital proceeds of the sale of your investment property are generally indicated by the sale price of the property on the contract of sale. However, this is not always the case.
If you are selling depreciating assets with your property, some of the contract price may be apportioned between the value of the depreciating assets sold and the property. If the sale values of each depreciating asset are not separately identified in the contract, this apportionment can be done on a reasonable basis. Generally, anything not attached to land or buildings is a depreciating asset, but given the potential complexities of the rules in differentiating them, speak to your accountant if you are not sure.
The attribution of some of the contract price to depreciating assets may give rise to a lower capital gain. However, if the amount apportioned to the depreciating assets exceeds the tax written down value of those assets, the difference will be a ‘balancing adjustment’ that is treated as income and is not eligible for the CGT discount. Therefore, you need to be careful to ensure that the apportionment does not create a worse overall tax position for you.
For instance, if the contract price for the sale of your property is $750,000, and $20,000 relates to depreciating assets (eg washing machine, clothes dryer, refrigerator, etc), and it just so happens that the total tax written down value of the assets also equates to $20,000, you will not have an assessable balancing charge but the capital proceeds for calculating the capital gain on the sale of the property will be $750,000 – $20,000 = $730,000, ie you will be reducing the capital gain by $20,000.
Market value substitution rule
Be careful if you are not selling the property under an ‘arm’s length’ transaction, which may happen if you are selling the property to a family member, for instance. If the sale has not resulted from an arm’s length transaction, and the agreed sale price is less than the market value of the property (ie what someone unrelated to you under genuine commercial negotiations without any duress would be prepared to pay for the property), the ‘market value substitution rule’ will be triggered and you will be deemed to have sold the property at market value. This market value will be deemed to be the amount of the capital proceeds on the sale, regardless of the actual sale price on the contract.
The cost base of a property, broadly speaking, includes the price you originally paid for the property, as well as the incidental costs (eg stamp duty, legal costs, and agent’s fees) you incurred in both purchasing and selling the property. These elements of the cost base are reasonably straightforward and the information should be easily obtainable if you have kept the relevant records.
Cumulative capital works deductions
There are a number of special rules that could modify the cost base of the property. For instance, if you have previously been entitled to claim the capital works deductions on the property, you will need to reduce the cost base by the cumulative capital works deductions which you have been entitled to claim if you purchased the property after 13 May 1997. However, if you bought the property on or before this date, you will legitimately be able to avoid this clawback.
Non-capital ownership costs
Meanwhile, if you bought the property on or after 12 August 1991, you can add to the cost base certain ‘non-capital ownership costs’ associated with that property that are not allowable as a tax deduction. For example, where the property ceased to be income producing for part of the time you owned it, the non-deductible expenses related to this time can be added to the cost base, including interest on funds borrowed to purchase and/or add capital improvements to the property, repairs and maintenance costs that are not capital in nature, insurance, and rates and land tax incurred on the property.
Property first used to produce income
An often-overlooked modification to the cost base is when you originally bought the property for a non-income-producing purpose but subsequently put the property to income-producing use after 20 August 1996 – in which case you are deemed to have acquired the property when it was first used to produce income at its market value at the time. In other words, the original purchase price becomes irrelevant when determining the capital proceeds on the sale of the property and you should consider obtaining a valuation to support the market value adopted.
Notwithstanding the deceptively simple formula for calculating the capital gain on the sale of your property, you may be entitled to further reduce the capital gain in calculating your CGT liability.
If the property you are selling qualifies for tax-free treatment for a period or periods of time during your ownership of the property
(eg under the main residence exemption), you may apportion the capital gain to exclude the portion of the gain that is attributable to the tax-free period(s) based on the period(s) during which the property qualifies for the exemption relative to your entire ownership period of the property.
This apportionment exercise may become dramatically more complicated if you have been able to utilise the temporary absence rules during your ownership period of the property, so careful analysis will be required to correctly calculate your apportioned capital gain and the resultant CGT liability in these circumstances.
CGT discount vs indexation methods
As mentioned above, if the property is held by an individual or a trust and has been held for at least 12 months before it is sold, then the capital gain derived from the sale may be halved for tax purposes under the 50% CGT discount.
Notwithstanding the CGT discount, many people are not aware that you are still allowed to use the ‘indexation method’, which enables you to uplift the cost base of the property by an index factor, which is calculated by dividing the consumer price index (CPI) for the quarter in which the property is disposed of by the CPI for the quarter in which the relevant cost base element was incurred – albeit you must use the quarterly consumer CPI that was frozen since the quarter ended 30 September 1999 as the ‘disposal CPI’, which is 68.7.
In some cases the taxable capital gain under the indexation method for assets acquired before 30 September 1999 may be lower than under the 50% CGT discount, which is why you should calculate the taxable capital gain using both methods to see which one will give you a better tax result.
It may not be advisable for you to simply assume the CGT discount
will always give you a better result. Consider the example of a property that was purchased in January 1986 for $350,000 that is subsequently sold after 30 September 1999 for $750,000.
CGT discount method
Taxable capital gain:
($750,000 – $350,000)
x 50% = $200,000
Taxable capital gain:
$750,000 – ($350,000
x 68.7/41.4) = $169,350
Goods and services tax
For completeness, you should always get advice on the GST consequences of selling the property, although nine out of 10 times the sale of residential premises generally does not give rise to any GST implications as the supply of residential premises is ‘input taxed’. However, if you are selling a commercial property, the GST consequences may be more complicated. By default, the supply of commercial property is taxable for GST purposes, and the liability will fall on you as the seller. However, if you are assigning an existing lease to the purchaser at settlement, you may be able to utilise the ‘supply of a going concern’ GST-free treatment to avoid paying GST on the sale. Even if GST is payable, the amount of GST payable may be reduced by the ‘margin scheme’.
Again, this area can be deceptively complicated, so working closely with your tax accountant who is well versed in property transactions is critical in ensuring that you have complied with all your tax obligations on the sale of your property.