Capital gains tax is an area of taxation that often confuses property investors. The legislation can appear complicated, however, all investors need to have a good understanding of it before selling an asset.
What is Capital Gains Tax
Capital Gains Tax was introduced in Australia in 1985 and applied to any asset you've acquired since that time unless specifically exempted.
According to the Australian Tax Office, a capital gain or capital loss on an asset is the difference between what it cost you and what you receive when you dispose of it.
You pay tax on your capital gains, which forms part of your income tax and is not considered a separate tax – though it's referred to as CGT.
Capital gains tax is the fee you pay on any profit made from the sale of an investment property. This profit is referred to as a capital gain. It is the difference between what you paid for the property (your cost base) and what you sold it for. It's included in your assessable income and taxed at your marginal rate.
You're likely to make a capital gain or capital loss when you sell or otherwise dispose of a rental property. If you make a net capital gain in an income year, you'll generally be liable for capital gains tax (CGT). If you make a net capital loss, you can carry it forward and deduct it from your capital gains in later years.
A capital gain, or capital loss, is the difference between what it cost you to obtain and improve the property (the cost base), and what you receive when you dispose of it. Amounts that you've claimed as a tax deduction, or that you can claim, are excluded from the property's cost base. The cost base of a capital gains tax (CGT) asset was generally the cost of the asset when you bought it. It also includes certain other costs associated with purchasing or acquiring, holding and selling or disposing of the asset.
If you acquired the property before CGT came into effect on 20 September 1985, you would disregard any capital gain or capital loss. However, you may make a capital gain or capital loss from capital improvements made since 20 September 1985, even if you acquired the property before that date.
So, when do you pay capital gains tax on an investment property?
A capital gains tax (CGT) event occurs when an asset is sold. The timing of this is essential as it determines the income year the tax will be applied. For property investors, a CGT event is triggered when you enter into a contract of sale and therefore stop being the owner of the property. The CGT is then applied in the same financial year you sold your property.
It's essential to keep thorough records of this process so you can correctly calculate the amount of capital gain or capital loss you make. Property investors are required to retain these records for five years after the CGT event occurs.
This is particularly important when you make a capital loss, as the amount can be carried forward as part of unapplied net capital losses. A capital loss does not reduce a taxpayer's assessable income. Instead, taxpayers can offset the loss against a capital gain in the current or future financial years.
How to calculate capital gains tax
A basic formula for calculating CGT is:
Selling price – transaction costs – original purchase price + associated transaction costs = capital gain (or loss)
If you have bought and sold an investment property within 12 months, your net capital gain will be added to your taxable income for that year. However, if you have owned an investment property for more than 12 months, there are two methods to calculate your net capital gain – discount and indexation. Depending on eligibility, you can choose whichever way reduces your capital gain the most.
Eg. If an asset is held for at least one year, then any gain is first discounted by 50 percent for individual taxpayers or by 33.3 percent for superannuation funds.
Capital gains tax exemptions
There are certain circumstances in which CGT can be exempt. CGT exemptions include 50 percent discount, principal place of residence, six-year rule and six-month rule.
Fifty percent rule: As previously mentioned, a property investor who has owned an investment property for more than 12 months are entitled to a 50 percent discount on CGT.
Primary place of residence: This refers to when a person resides, occupies and lives in a property as their home. If a property is considered an owner's primary place of residence, the property owner is entitled to a full CGT exemption.
Six-year rule: If a property owner moves out of a primary place of residence and rents it out, they can claim an exemption from CGT for a period of up to six years. If a property owner moves back into the property and afterwards moves out again, then a new six-year period commences from the time they last moved out.
Six-month rule: There are exemptions from CGT if a property owner considers more than one property to be a primary place of residence within six months. The property owner must meet one of the below conditions:
- The old property was the owner's primary residence for at least three months in the twelve months before they sold it
- An owner did not use the property to provide assessable income in any part of the twelve months before selling
How to Avoid CGT?
One downfall to renting out an investment property is the capital gains tax (CGT) that will be payable upon the sale of the property. CGT is the tax charged on capital gains that are procured from an asset. You are liable to pay this tax when your capital gains exceed your capital losses in an income year.
However, there are legal ways to avoid paying CGT while renting out your house. Capital gains tax exemptions are allowed by the Australian Taxation Office (ATO) under specific scenarios.
People's lives are continually changing. Whether it's due to a change in future plans or circumstances, there are many reasons why you may decide to lease out your principal place of residence. To do this without incurring CGT, be sure to understand the ATO's rulings concerning this topic.
The following simple rules apply:
- Only your principal place of dwelling will be exempt from CGT. Thus you can't own two properties, live in one for a couple of years and then alternate between that property and your principal residence while avoiding paying CGT on both houses.
- Usually, if you purchased a house after 7.30 pm on 20 August 1996, you have to have lived in it when it was first bought (i.e., not rented it out) to be entitled to a full exemption. This is because by renting the property straight away, the ATO deems you to have acquired the property purely as an investment to produce income.
- Provided the above terms are met, you are exempt from CGT if you rent out your home for less than six years.
- If you've held a property for more than 12 months and the ATO has deemed you subject to CGT, you are entitled to a 50% discount.
Capital gains tax is dependant on individual circumstances, and as such, claims can become quite complicated. This is especially true where you own multiple properties and increase the frequency with which you move from one property to another.
If you're selling an investment property, the CGT calculation is based on the sale price of a property minus your expenses. These expenses are called your cost base. The cost base is the total sum of the original purchase price, plus any incidentals, ownership and title costs minus any government grants and depreciable items. Depreciable building items were not included in the cost base calculations before 1997.
Incidental costs - stamp duty, legal fees, agent fees and advertising and marketing fees.
Ownership costs - rates, land tax, maintenance and interest on your home loan. Note that you can only add rates, land tax, insurance and interest on borrowed money to your cost base if you acquired the property after 20 August 1991 or didn't use the property to produce an assessable income, e.g. vacant land or principal residences.
Improvement costs - replacing kitchens, bathrooms or any other improvements you've made on the property
Title costs - legal fees associated with organising and defending your title on the property
Capital losses can be offset against capital gains, and net capital losses in a tax year may be carried forward indefinitely.
However, capital losses cannot be offset against regular income.
According to the ATO, most personal assets are exempt from CGT, including your home, car, and most personal use assets such as furniture. CGT also doesn't apply to depreciate assets used solely for taxable purposes, such as business equipment or fittings in a rental property.
If you're an Australian resident, CGT applies to your assets anywhere in the world.
Foreign residents make a capital gain or capital loss if a CGT event happens to an asset that is 'Australian taxable property.'
When you sell or otherwise dispose of an asset, it's called a CGT event, which is the moment when you make a capital gain or capital loss.
It's also essential to establish the timing of a CGT event because it tells you in which income year to report your capital gain or capital loss, and may affect how you calculate your tax liability.
If you dispose of a CGT asset, the CGT event usually happens when you enter into the contract for disposal.
In the case of real estate, for example, the CGT event generally occurs when you enter into the contract – that is, the date on the contract, not when you settle.
Avoiding Capital Gains Tax by living in the property
When it comes to property, one of the significant exemptions from Capital Gain Tax is if it's your home or principal place of residence (PPOR).
You can generally claim the principal residence exemption from CGT for your home.
To get the exemption, the property must have a dwelling on it, and you must have lived in it.
You're not entitled to the exemption for a vacant block.
Generally, a dwelling is considered to be your principal residence if:
- You and your family live in it.
- Your personal belongings are in it.
- It is the address your mail is delivered to.
- It is your address on the electoral roll, and
- Services such as phone, gas, and power are connected.
There is also a tax break that you may be able to access if your PPOR becomes a rental property.
There is a special six-year rule, which means that a property that was previously your PPOR can continue to be exempt from CGT if sold within six years of first being rented out.
The exemption is only available where no other property is nominated as your principal residence.
What's interesting about this rule is that if the same dwelling is reoccupied as your principal residence, then the six-year exemption resets.
So another six years of exemption is available from the date it next becomes income-producing.
Paying Capital Gains Tax if your principal residence is used for business
Advancements in technology mean that more and more people are working either from home or working for themselves. Man Signing Contract
A tax issue that many people find themselves in, however, is that if they work from home or use the home for business purposes, that may trigger some form of CGT.
It's important to understand that if your employer has an office in the city or town where you live, your home office will not be a place of business, even if your work requires you to work outside regular business hours.
Also, if your income includes personal services income, you may not be able to claim a deduction for occupancy expenses.
According to the ATO, it's essential to consider any CGT impacts of claiming your home as a business premise.
To work out the capital gain that is not exempt, you need to take into account several factors including:
- The proportion of the floor area of your home that is set aside to produce income.
- The period you use it for this purpose.
- Whether you're eligible for the "absence" or six-year rule
- Whether it was first used to produce income after 20 August 1996.
Avoiding Capital Gains Tax with a Self-Managed Super Fund
The ability to borrow money to invest in property, in particular, by using the mechanism of an SMSF has resulted in the number of funds increase rapidly in recent years.
Close to 600,000 SMSFs are now in operation, according to the latest statistics released by the Australian Taxation Office (for December 2015).Avoiding-Capital-Gains-Tax-with-a-Self-Managed-Super-Fund
While people have generally always been able to buy a property through SMSFs, a few changes have been made recently. SMSFs can now borrow money to do so.
Buying a property through an SMSF should not be the sole reason that someone chooses to set up an SMSF, but it can be an option for people who want more control over their super.
Similarly, it's essential not to consider buying the property with an SMSF solely as a way to avoid or minimize, paying CGT.
It should work for your long-term investment strategy as well as meet several checks and balances for your financial future.
If you do choose to invest in property using an SMSF, the unique ownership structure provides several taxation benefits.
If you sell the property once you've retired, you'll pay no capital gains on the property.
There's also a 33 percent discount available under the CGT discount method calculation.
Borrowing or gearing your super into the property must be done under rigorous borrowing conditions and can present investment risks.
Some of the property risks associated with geared real estate bought via an SMSF include:
Higher costs – SMSF property loans can be more costly than other property loans, which must be factored into your investment decision. Home Finances
Cash flow– loan repayments must be made from your SMSF, which means your fund must always have sufficient liquidity or cash flow to meet the loan repayments.
Hard to cancel– If your SMSF property loan documentation and contract are not set up correctly, unwinding the arrangement may not be allowed, and you may be required to sell the property, potentially causing substantial losses to the SMSF.
Possible tax losses– Any tax losses from the property cannot be offset against your taxable income outside the fund.
No alterations to the property– Until the SMSF property loan is paid off, modifications to a property cannot be made if they change the character of the property.
Holding an asset for more than 12 months
While this isn't technically an exemption, if you buy an investment property and keep it for more than 12 months, you're entitled to a 50% discount on the amount of CGT payable. The discount is 33.3% for super funds.
Investing in affordable housing
From 1 January 2018, investors who invest in qualifying affordable housing will receive an additional 10% discount, bringing their CGT discount to 50%. To qualify, the investment property must be provided below-market rent and made available for tenants on low to moderate incomes. Registered community housing providers must also manage it, and the property must be held as affordable housing for a minimum of three years.
CGT Discount for Foreign Residents Individuals
There are individual capital gains tax (CGT) rules you need to know if you're a foreign resident for tax purposes. These rules will impact you when you sell residential property in Australia.
On 12 December 2019, a law change means you can no longer claim the CGT principal residence exemption unless, when a CGT event happens to your residential property in Australia, you were a foreign resident for tax purposes for a continuous period of six years or less. During that time, one of the following occurred:
- you, your spouse, or your child under 18, had a terminal medical condition
- your spouse, or your child under 18, died
- the CGT event involved the distribution of assets between you and your spouse as a result of your divorce, separation or similar maintenance agreements.
This applies to you:
- when you use the exemption as a reason for a variation to your foreign resident capital gains withholding rate
- when you lodge your income tax return
- you must declare any net capital gain in your income
- you can claim a credit for the foreign resident withholding tax paid to us.
When the change applies
The change applies to foreign residents for tax purposes as follows:
- For property held before 7:30 pm (AEST) on 9 May 2017
- the CGT principal residence exemption can only be claimed for disposals that happen up until 30 June 2020 and only if they meet the other requirements for the exemption
- disposals that happen from 1 July 2020 are no longer entitled to the CGT principal residence exemption unless certain life events (listed above) occur within a continuous period of six years of the individual becoming a foreign resident for tax purposes
For property acquired at or after 7:30 pm (AEST) 9 May 2017
- The CGT principal residence exemption no longer applies to disposals from that date unless certain life events (listed above) occur within a continuous period of six years of the individual becoming a foreign resident for tax purposes.
Note: This change only applies if you are not an Australian resident for tax purposes at the time of the disposal (when you sign the contract to sell the property).
If you weren't an Australian resident for tax purposes while living in your property, you are unlikely to satisfy the requirements for the CGT principal residence exemption.
If you are a foreign resident for tax purposes when you die, the changes also apply to:
- legal personal representatives, trustees and beneficiaries of deceased estates
- surviving joint tenants
- special disability trusts.
Up to 8 May 2012, the CGT discount of 50% was available to foreign resident individuals who were subject to CGT on Australian taxable property.
For assets acquired after 8 May 2012, the discount is generally not available to foreign and temporary resident individuals (including beneficiaries of trusts and partners in a partnership).
The discount is apportioned where a CGT event happens after 8 May 2012 and:
- you acquired the asset before that date, or
- you had a period of Australian residency after that date.
CGT events that occurred before 8 May 2012 are not affected.
Foreign and temporary residents
You must calculate the CGT discount you can apply to the capital gain if you're a foreign or temporary resident individual and, after 8 May 2012, you have a discount capital gain from a CGT event.
If you were a foreign or temporary resident on 8 May 2012, you might choose to get market value for the CGT asset as at 8 May 2012 and use a market value calculation. This will apportion the CGT discount to take into account the capital gain you accrued before 8 May 2012.