The sacred cow of the Australian tax system is without a doubt the family home, and it is well known that in the simple case there is no capital gains tax (CGT) paid when buying and selling your main residence.
What happens, however, when things are not quite so simple? Here are four common variations where at least a partial CGT exemption is available.
Going overseas – the six year absence rule
This rule allows the family to move out of their home and continue to treat it as CGT exempt for up to six years even while renting it out, as long as they don’t own another property on which they wish to claim a CGT exemption. It is usually applied when people go overseas to work for, say, two-to-three years, then move back into their house on their return, allowing the house to remain totally CGT free when it is later sold. The six year rule can apply equally where someone moves out of their home, rents it out to tenants, and themselves move into rented accommodation. A common variation on that theme is someone in their 20s buying an apartment, lives in it for say six – 12 months, and then moves back in with mum and dad.
It is also possible to buy a second property to live in and use the six year absence rule for their original house. The trade-off is the second property will be exposed to CGT on sale. A partial exemption applies where the absence period exceeds six years, and this can mean, for example, that someone who sells their former family home after seven years while still living overseas would be taxed on one-seventh of the increase in value during the period. It is important to note that under recently introduced changes, non-residents would no longer be able to claim the main residence exemption for properties sold after 30 June 2019.
The family home becomes an investment property
Another common situation is for someone to move out, usually buying another house that will become their new home, and turning their original home into an investment property. This could happen in a variety of ways. Take the case of James and Lisa, for instance. James and Lisa each own an apartment, and James moves into Lisa’s apartment which becomes their collective home, so James starts leasing out his apartment. After two years the couple buy a house to live in, deciding to keep Lisa’s apartment as another investment property and leasing it out to tenants.
Many years later the two apartments have been sold and the family is still living in the same house. Having finally seen their children move out of home, James and Lisa decide that it is time to down-size and buy a new townhouse closer to the city, keeping the house as an investment property. In each of these cases the property has been the owner’s main residence since they bought it, so the CGT rules treat it as having been acquired at the current market value at the date that they started renting the property. This means changes in the value for the period during which they actually lived in the property are ignored, and it only increases (or decreases) going forward up to the actual sale date that are considered for CGT purposes. The clock also restarts for applying the 50 percent CGT discount, so the property must be owned for a further 12 months before the discount comes into play.
The family home is used to derive assessable income
If the family home is used to derive assessable income, perhaps through Airbnb, when it is sold it will be necessary to calculate the capital gain and then pay capital gains tax on the portion that relates to the income producing activities. This tax is often not taken into account when considering using the home to derive income.
An investment property becomes the family home
This can be a case of doing things the wrong way around as it is the opposite of the six year absence situation. Unfortunately the exemption is only for the period someone actually lives in the property, calculated on a pro rata basis. For example, Sally buys an apartment as a rental property and after two years decides to move in for a further three years before selling it.
Having bought for $500,000 and sold for $750,000, the capital gain of $250,000 is apportioned for the period before Sally lived in the apartment, being 40 percent of the total, that is, $100,000. After applying the 50 percent CGT discount, Sally will have a taxable capital gain of $50,000.
It is possible to combine some of these special rules to maximise the CGT exemption. Take the example of Julia and her family who have lived in their house for 10 years. She is offered an opportunity to work in the US, staying in accommodation provided by her employer. After eight years they are still in the US, so decide to sell the Australian house.
Using the six year absence rule Julia is exposed to CGT for the final two years before the sale, and the taxable capital gain is calculated as 25 percent (two years out of eight) of the difference between the sale price and the market value at the date they moved to the US. The first 10 years when the family was living in the house are ignored, and the taxable capital gain calculated as:
This position will change after 30 June 2019 as Julia would be a non-resident at the time of the sale. One way to achieve a better outcome is to hold off selling the property until after the family returns to live in Australia, so at least a partial CGT exemption can be claimed.
When a relationship breaks down the couple will often go from having one main residence to two. The tax rules do not allow a full exemption on two properties and so the position should be determined as part of the financial settlement.
Careful planning needed
It can be seen from these examples, of which there could be at least a dozen other variations, that the CGT main residence exemption is far from simple. Despite those immortal concepts expressed so eloquently by Denis Denuto and Darryl Kerrigan that “a man’s home is his Castle” and its “the vibe”, the rules contain many traps and opportunities that need careful planning to get the best outcome, without raising any unwanted questions from the ATO.