Investment properties are usually subject to capital gains tax (CGT). This means that a portion of the money you make as profit on real estate assets is given to the government when you sell. This can be a substantial sum, potentially worth hundreds of thousands of dollars and is usually based on your individual income tax rate.
It’s not a tax that investors love to pay. Thankfully, your primary place of residence is exempt from this tax, as it allows homeowners not to have their own residence treated as an investment. Clearly, paying this tax as a homeowner would also impact on their ability to upsize or downsize.
However, there is a specific rule that allows some property owners to rent out their home and avoid CGT. This is called the six-year rule.
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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.
If an asset is held for at least one year, then any gain is first discounted by 50 per cent for individual taxpayers or by 33.3 per cent for superannuation funds.
What is the six-year rule?
The Australian Taxation Office explains that the six-year rule allows you to treat a dwelling as your main residence for up to six years if it is used to bring in income. This means you wouldn’t have to pay CGT if you sold.
It also means that, if you don’t use it to bring in money, you can hold onto the property indefinitely without paying a tax on your profits. This could be the case if you decide to hold onto it as a holiday home.
If you are getting into property, or already are so, you may already know of the six-year rule. If not, that is more than acceptable as tax law is not exactly weekend reading material. However, with a little knowledge, you may stand to save thousands on your taxes when you do come to sell your property.
It all revolves around treating your dwelling as your main residence, even after you have moved out. When you purchase a property, you have a choice to treat it as a primary place of residence (PPOR) or as an investment. If you do not live in the property for at least 12 months after purchasing it, you may not treat it as a PPOR. Remember this!
However, after you live in this property for 12 months, you can move out of the residence and rent it out for up to six years and apply for a capital gains tax exemption from the income you derive each year and on the sale of that property. Remember, as long as you sell within six years.
Of course, no one capital gains shoe fits all. If you do not rent out your PPOR after moving out of it, you may do this indefinitely and still claim a capital gains tax exemption when you sell the property. For example, you buy a property and live in it for the first year, then move out and rent somewhere while your son lives in the property free of charge.
What if you are absent from your PPOR more than once? That is, you might move interstate more than once and return to live in your property more than once. The ATO treats each period you are not living in your PPOR and renting it out as a separate occasion. You can then avoid paying Capital Gains Tax as long as none of these periods exceeds six years.
The Income Tax Assessment Act 1997 gives this example: You live in a house for 3 years. You are posted overseas for 5 years, and you rent it out during your absence. On your return, you move back into it for 2 years. You are then posted overseas again for 4 years, at the end of which you sell the house. You may choose to continue to treat the house as your main residence during both absences because each absence is less than 6 years.
If you acquire multiple investment properties during this period, the six years is cumulative. The ATO does not treat these separately. So, if you earn income on your PPOR for say, 8 years, spread over a few different stints depending on your movements, you will pay tax on the two years following the first six years of cumulative income.
What’s the catch?
There are some caveats to the rule. Firstly, you can’t treat another property as your official main residence for this same time period – unless you happen to be moving from one home to another, in which case the rules are slightly more flexible for this period of time.
You also need to ensure the home was considered your primary place of residence when you initially bought it. It can’t have been an investment property to start with.
Why is the rule in place?
There are many reasons you may not be living in your home for a stretch of time, which is why this rule has been created - to ensure homeowners don’t get caught up in paying tax. It also means you can make some additional money from your own home for a period of time without triggering CGT.
The six-year rule allows you to move out of your residence, rent somewhere else and rent out your former home, and then sell it before the six-year period is up without having to pay CGT.
What if I rent it out for more than six years?
If you earn income from the property for more than six years, anything over the six years will be apportioned to work out how much tax is owing. This will divide the amount of time over and above the six years into the time of full ownership and will use this figure to separate out a portion of the profits that is applicable to CGT. The value of the property when you first started using it to earn income (based on the comparative market value at the time) is used to determine the gains after this point.
The six-year rule resets each time you move back into the home for a period, provided each absence is less than six years.
As with all tax-related factors, it’s worthwhile speaking to your investment team and your accountant before making any major decisions. These rules apply to homes used to produce income after 1996. Always seek independent advice to maximise your investments.
Tax On Non-residents
Non-Australian tax residents can acquire residential rental properties for the same costs as tax residents. These include purchase price, stamp duty (a state-based tax) and legal fees for the conveyancing of the property from the vendor to the buyer.
At your discretion, you should include a sourcing fee for a buyer’s agent to help you locate the type of property you specify. It is also prudent to pay for a pest and building inspection report before finalising the purchase.
Positive net rental income is taxable where the property is rented. Rental losses can be carried forward to be offset against future income for an indefinite period. The losses can also be offset against any capital gain derived on sale of the property.
If a capital gain is derived on the sale of a property after it has been owned for more than 12 months, residents get a discount of 50% before the remaining 50% is taxed. Non-residents cannot access this concession.
Income-tax rates for non-residents are slightly higher than those for residents. The major difference is that the first $18,200 of income is taxable for non-residents, while it is tax-free for residents. From $18.2k to $37k, residents are taxed at only 19%, while non-residents are taxed at 32.5%.
A state-based tax – land tax – is payable where the land value exceeds a threshold. Land tax rates vary between the states; in NSW, it is 1.6% of the land value, and the threshold is $406k. The land value above this amount is taxable.
As for residents, interest expenses incurred in financing the purchase of a property are tax-deductible against the rental income. Consult your property tax specialist for advice on tax planning before you enter into a transaction.
CGT When Selling A Previously Rented PPOR
On first being purchased, a property can be established as either a main residence or a rental investment. The nature of the first usage of the property will dictate how the capital gain is calculated on sale at a profit.
Whenever a property is occupied as a main residence, it is exempt from capital gains tax (CGT) for that period of time. Under the six-year rule, a property 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 the main residence.
So, if you relocated for work purposes in 2010 and continued to nominate your property in Victoria as your main residence, you will maintain your exemption from CGT when you realise a capital gain on selling it after four years of first renting it out.
If you nominated another property, which you purchased, as the main residence during that time, the cost base for calculating the CGT on sale would be the market value at the time you nominated the new property. This means any capital growth accrued until then will be exempt.
The six-year rule, in short, means you can own a property that you treat as your main residence for capital gains tax purposes even though you do not live in that property. If you are producing income from this property, i.e. earning rent from it, you can treat that property as your main residence and be exempt of capital gains tax (CGT) for up to six years even though you are not living there.
If you do not sell the property within those six-years or reoccupy the property as your main residence within those six-years, then the exemption no longer applies. During this six-year period, you cannot nominate another property as your main residence; otherwise, you will not be exempt from Capital Gains Tax.
Here are some examples of where the six-year rule applies and where it would not apply:
Property that was previously your principle place of residence (PPOR) earns no income
Nina and Dave bought their first home in Melbourne in 2009 to be there principle place of residence (PPOR), but in 2012 Nina was contracted to work in Sydney for two years. The couple decided to rent an apartment in Sydney while they left their Melbourne home full of their larger belongings and asked Nina’s sisters collect their mail every week. Nina’s work contract was extended in Sydney, so Nina’s sister moved in their Melbourne house rent-free indefinitely.
Seven years later Nina and Dave sold their house in Melbourne and were able to claim the main residence exemption from CTG as they were earning no income from the house and they did not nominate the apartment in Sydney as their PPOR.
Property that was previously your principle place of residence (PPOR) now earns income
Colin bought a one-bedroom studio apartment in Brisbane as his PPOR in 2010. In 2012 he met Alex, and they decided they needed a bigger space, so they started renting out the apartment while renting a larger home 15 minutes away. 4 years later, they found the house of their dreams and decided to sell the apartment.
The two treated the apartment as their main residence for those 4 years, and as the period of time they were not living in the main residence was less than 6 years they were exempt from CGT.
Property that was previously your principle place of residence (PPOR) went through periods of being rented out and living in by the owners
Cleo has lived in her townhouse she purchased two years ago, but she was in need of sea change. Cleo decided to rent a home in a small seaside town for a year while she rented out her townhouse. After the year was up, she moved back into her townhouse.
Two years went by again, and it was time for another change of space. Cleo rented an apartment in a high-rise building for two years while again, she rented out her townhouse. Cleo finally came back to her townhouse for good after the two years were up.
If Cleo were going to sell her townhouse which has been her main residence the whole time, she would be exempt of CGT as each period that she was earning income from her townhouse and living in another place was less than 6 years.
Avoiding Capital Gains Tax by living in the property
When it comes to property, one of the major exemptions from Capital Gain Tax is if it’s your home or principal place of residence (PPOR).
You can generally claim the main 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 main 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 which 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 main residence.
What’s interesting about this rule is that if the same dwelling is reoccupied as your main 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 main residence is used for business
Advancements in technology mean that more and more people are working either from home or working for themselves.
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 normal 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 important to consider any CGT impacts of claiming your home as a business premise.
If you rent out your property for six years or less, you can use this to gain a full capital gains tax exemption, as long as you’re not treating another property as your main residence.
While this is commonly called the “6-year rule,” it doesn’t refer to six calendar years. It only refers to the time your property has an active tenant. So, for example, you rented out a property for eight years, but it stayed vacant for several months that add up to two years, you’re still eligible for this exemption.
The goal isn’t just to learn how to avoid capital gains tax when selling an investment property but to do it within the limits of the law. With the strategies on our list, you can significantly reduce your capital gains tax legally. Remember, you always have to pay your dues, but that doesn’t mean you have to pay more than what you should.