Ask Max: Your questions answered

A case study in capital gains tax and main residence exemption, plus how to take advantage of dividends.

PORTFOLIO POINT: Max Newnham has spent 30 years working with – and writing about – small businesses and SMSFs. Each week he draws upon this experience to answer the questions of Eureka Report subscribers.

This week:

  • Changing residence and CGT implications.
  • We’re considering making our son a trustee in our SMSF.
  • How can I take advantage of fully-franked dividends?
  • Should I take my super as a lump sum?

CGT and main residence exemption

I have lived in my house for 12 months in the past three years and I'm considering subdividing and building two houses. I am considering living in one of them and either renting or selling the other one. What would the CGT implications be?

Could I live in one house and rent the other one out for 12 months, then sell and claim the residence exemption on the property I lived in, then move into the second house and claim the exemption on the sale after living in that one for 12 months?

The capital gains tax laws relating to the main residence exemption are complicated, especially when a property is used to produce income. In fact, in a recent answer to a question I didn’t quite get the answer right.

Like most things to do with income and CGT, the date when something happens is critical. Firstly, if any asset was purchased before September 20 1985, CGT does not apply. One of the few assets exempt for tax, no matter when it was purchased, is a person’s residence.

There are two circumstances where a residence can either cease to be exempt from CGT, because it is used to produce income, or where an income-producing property becomes a residence and therefore becomes exempt from CGT.

When the CGT status of a property changes, there are two methods that can be used. They are the “days of ownership” method and the “market value” method. However, when income is earned from a property after August 20 1996, the market value method must be used if the full residence exemption applied to the property immediately before income started to be produced.

Under the market value method, the owner is deemed to have acquired the property at its market value at the time the property first starts to produce income. Where a property is first used to produce income, and then becomes a person’s residence, the assessable capital gain is calculated on a days of ownership basis.

If you rented out the house you are currently living in for the first two years of ownership, and only lived in it for the past 12 months, and then sell it, one third of the gain would not be taxable due to the main residence exemption.

The new house you build and move into as your residence will be exempt from tax. The other house you rent out then move into will be taxed on the time basis. This means if you rented the house for 12 months, then lived in it for 12 months, half of the gain would be capital gains exempt. You should seek professional advice because you could be liable for GST on the property that you build and rent out.

If you lived in one of the new houses, rented it out, and then sold it, you would have to use the market value method. This would involve getting a valuation of the property at the time it is rented. Any increase in value from the time it is rented until sold would be taxable.

A further complication arises if you rent a house but don’t buy a new residence. This can occur if you move away from your home, rent it out while you are away and also rent a property in the location you have moved to. When this occurs, you can regard the property as your residence for up to six years.

If you move back within six years and sell the property, no CGT is payable. If you do not move back in, rent the property for longer than six years, and then sell it, you will have to use a combination of the market-value method and time-owned method to calculate how much CGT is payable.

For example, if you bought a property in January 2000, lived in it until January 2002 then moved overseas to work, and rented out the property until January 2010 when it was sold, you would need to establish the market value of the property in January 2002. You would then pay tax on approximately 20% of the difference between its net selling value and its value in January 2002.

As you can see, this is a very complicated area of tax law and you should seek professional advice before making any decisions.

SMSF trustees

Currently my wife and I are the trustees of our SMSF. If our son was to join the fund and become a trustee, would that negate the fund becoming non-compliant if one of us died?

Having your son as a trustee will mean that when one of you dies, the fund can continue uninterrupted. You will, however, need to include his name as trustee on all investments for the super fund.

Fully-franked dividends

I am self-employed and gross around $140,000 per annum, and I’m wondering how best to use fully-franked share dividends. I don’t need the income. One obvious option is to take the dividends as shares. The other is to receive the cash and invest it into my super fund and gain the tax deduction. What are your thoughts?

If you reinvest the dividends as extra shares this will not fix your problem; it will actually make it worse. You will still have to pay the tax on the dividend, but won’t have the cash. If you contribute the cash dividend to your super fund, unless you are self-employed, you will not receive a tax deduction.

You could consider taking out a loan to purchase more shares. The interest would be tax deductible and the cash dividend from your current shares would help fund the interest and loan repayment. Before embarking on this strategy, you should seek professional advice.

Taking super as a lump sum

My superannuation is currently worth about $630,000 and I will be turning 65. If I take out my super as a lump sum and put it into, say, a term deposit at a bank, will it be covered by the Australian government deposits guarantee? I understand the maximum deposit guarantee is now $250,000. Will I be covered if I put it into accounts at three different banks, or if I put it into separate accounts in my name, my wife's name, and perhaps joint names?

I must say I am totally bewildered as to why you would want to take out your entire super. The tax and Centrelink benefits you get from having this money in super are considerable and before doing this you should get professional advice.

You are right about the maximum guarantee being $250,000. This applies to accounts with each bank held by individuals and entities. This means the maximum guarantee a couple is eligible for is $500,000 with any one bank. To have all of your money subject to the guarantee, you would need to split your funds between two banks.

Max Newnham is a partner with TaxBiz Australia, a chartered accounting firm specialising in small businesses and SMSFs.

Note: We make every attempt to provide answers to readers’ questions, however, answers are of a general nature only. Subscribers should seek independent professional advice for more in-depth information that is specific to their situation.

Do you have a question for Max? Send an email to askmax@eurekareport.com.au