Capital gains tax explained, Part 3: Investment property appreciation

Capital appreciation often forms a large part of the return on an investment property. In general, investors are liable to pay tax on that capital gain.

This is part of a series. To see Part 1, common misconceptions around capital gains tax, click here. To see part 2, around capital gains tax payable on deceased estates, click here.

The rules on when and how much tax applies are not straightforward, particularly when the investment property starts out as the owner’s primary residence, or becomes the owner’s home after having been rented out for a period of time.

“The fundamental principal is that a taxpayer’s main residence is exempt from CGT and that a taxpayer can only have one main residence,” says HLB Mann Judd director of tax Bill Nussbaum.

“Commonly, circumstances can change, especially when the main residence is also used for income producing purposes for certain periods of ownership. Such circumstances include absences from the property and renting out the property for the first time.”

Nussbaum prepared the following case study examples for Property Observer to illustrate the CGT outcomes in various situations. Each person’s circumstances are different and you should seek professional tax advice if you have questions on how CGT applies to your situation.

Primary residence becomes an investment property

Absences & the “Six Year Rule”

2. The main residence home is rented out as the taxpayer is transferred to another city/overseas or decides to move to rented accommodation and keep the existing home.
   
   
3. Home therefore stops being a “main residence”.
   
   
4. The “Six Year Rule” allows the taxpayer to continue to treat the home as their main residence for a maximum period of six years (See Example 1)
   
   
5. If the taxpayer moves back into the property after having rented it out for some time and re-establishes it as the main residence, a further period of six years starts to run if the property is rented again in the future.
   
   
6. If the “Six Year Rule” is breached, as the property is rented for more than six years, then a partial exemption is applicable (See Example 2)

Special rules

1. In addition to the “Six Year Rule”, there is also a special rule for properties which first become income producing after August 20, 1996.

2. The Special Rule relates to determining the cost base of the property.
   
   
3. The property is assumed for tax purposes to have been acquired at its market value when it was first rented out, rather than the actual purchase price.

Example 1: Dwelling first used to produce income – “Six Year Rule”

On July 1, 1994 Bev paid $250,000 for a house that she used as her main residence until July 1, 2007, at which time its market value was $350,000.

If Bev then rented the house until she sold it before July 1, 2013, she would still be able to claim a full CGT exemption by relying on the six-year extended exemption. She would not have to pay CGT on the sale proceeds.

Example 2: Dwelling first used to produce income – Breaching the “Six Year Rule”

Following on from Example 1, if Bev continued to rent the house before selling it for $700,000 on July 1, 2014 (seven years after its first income use), she could only claim a partial exemption for CGT.

In that case, the market value of the house at the time of its first income use ($350,000 on July 1, 2007) is used to determine the capital gain because the property first became income-producing after August 8, 1996.

The capital gain in this case is $350,000 ($700,000 − $350,000 = $350,000). The taxable capital gain would be worked out (ignoring leap years) as follows:

Since Bev has held the property for more than 12 months, a 50% CGT discount would apply. She would have to pay CGT at her marginal tax rate on $25,000 (ie 50% of the $50,000 capital gain).

Investment property becomes a main residence

Only a partial main residence exemption is available if a property is initially rented out as an investment and then becomes the taxpayer’s main residence for part of the ownership period. If the residence is used as a rental property initially, the overall capital gain on eventual disposal is reduced via a pro rata apportionment by reference to the period the taxpayer used the property as their main residence, as explained in Example 3.

Example 3: Former investment property- now main residence

Lisa acquired a dwelling on October 19, 2008 which she let out to tenants until October 21, 2011. From that date she used the dwelling as her main residence. Lisa eventually sold the dwelling on September 7, 2013 and made a capital gain of $40,000, calculated without regard to the CGT exemption provisions. The capital gain is reduced pro rata by reference to the period Lisa used the dwelling as her main residence. The reduced capital gain is:

As Lisa has owned the property for more than 12 months, she would be entitled to the CGT discount and would have to pay tax on $12,302.50 (50% of $24,605).

Do you have any queries about CGT? Email news@propertyobserver.com.au