Question Mark

With just six weeks until the end of the financial year, the hot issue for property investors is, as always, capital gains tax: does it affect you, and how can you (legally) minimise it?

Today’s questions focus predominantly on tax issues; you can read my responses below.

First, to help get your head around the weird and wonderful world of CGT and how it relates to you, it’s worth knowing a few key facts:

1. If you buy a property and rent it out as an income-producing investment from the outset, come sale time you’ll be liable for CGT on any capital gain.

2. If you buy a property, live in it, move out, rent it out as an investment asset, then buy another home to live in, you’ll be liable for CGT on capital gains the first property makes from the time you move out until the time you sell it.

3. If you buy a property, live in it, move out and rent it out as an investment asset but don’t buy another home to live in, you can hold the property for up to six years without any CGT liability.

4. When determining the financial year in which the CGT is to be paid, the tax office uses the date of sale on the contract, not the date the contract settles. For example, if you sell on June 28, 2006, and settle on August 28, 2006, your CGT will be payable for the 2005-06 financial year. If you’re looking to push any CGT liability into the 2006-07 financial year, the date of sale on the contract must be later than June 30, 2006.

With these facts in mind, read on for the answers to this week’s curly questions'¦

Ins and outs

I own a unit in Sydney. I lived there for five years and travelled overseas for another five. I rented the unit out while I was overseas.

I returned to Sydney and lived in my unit for five more years before retiring and moving to Queensland four years ago. I own the unit I currently live in, although I originally purchased it as an investment property when I was overseas. I rented it out for four years until moving in myself.

I would like to sell my Sydney unit later this year. Can I still claim it as my main residence and avoid paying capital gains tax?

You are only entitled to claim one property as your main residence at any one time. The tax office allows you to move out of your home and claim it as your main residence for up to six years, provided you don’t purchase and live in another property.

Because you rented out your Sydney unit for less than six years at any one time, you can claim it as your main residence from the time you purchased it until the time you moved into your Queensland property.

Therefore, your Sydney unit will be exempt from CGT on any capital gain it achieved from the time you bought it until the time you moved in to the Queensland property.

You will be liable for CGT from the time you moved into your Queensland unit until the time you sell the property. Because you held the property for more than 12 months you will be entitled to a 50% CGT discount. This means only half the capital gain will be taxed.

To calculate your exact CGT liability for this period, you will have to ask a qualified valuer for a valuation of your Sydney unit at the time you moved out.

CGT is a very complex area. I suggest you talk to your accountant for a more detailed review your position before taking any further action.

House hopping

I bought my home in 1971. I also purchased several investment properties, each rented out for more than 10 years.

Can I progressively live in these investment properties for at least 12 months apiece and claim them as my main residence before selling them? I want to reduce or eliminate capital gains tax.

Capital gains tax is only payable on capital gains for investment properties bought after September 19, 1985. If you bought properties before this date, you won’t pay CGT on them, even if you held them as investment properties and received rental income.

If you bought any of your investment properties after this date, your CGT liability would be determined on a pro rata basis.

Example:

• Purchase an investment property in 1990.
• Rent it out for eight years.
• Live in it for five years.
• Sell the property.

In this case the first eight years of growth would attract CGT; the last five years would be CGT-exempt.

As for your question about progressively living in your investment properties for 12 months at a time and claiming them as your main residence to reduce or eliminate capital gains tax, the tax office won’t allow you to reduce or eliminate your CGT liability by living in your properties for 12 months, claiming the main residence exemption and then selling them. It opens you to liabilty for tax evasion and breaking the law.

The only portion of capital gains that will be exempt from CGT is the portion achieved during the period you lived in the properties '” and this exemption will only apply if you don’t claim another property as your main residence during that 12 month period.

Lease-back plan

I’m thinking about selling my residential home in Perth to an investor and then leasing it back from them. I would use part of the cash from my sale to retire debt. I still owe the bank $100,000 on my house, which is worth $750,000.

I would use the rest of the sale proceeds to top up my super. I am 53 and can readily get a 20–30% annual return on the super fund I have been investing with. Thanks to last week’s budget changes, in seven years, when I reach 60, I can withdraw any amount, tax-free, although I think I will still pay 15% on the funds on the earnings from the fund. What do you think of my plan?

First, you should establish how much rent the investor will charge you. I suggest they will want an annual return of at least 3.5%. This equates to about $26,000 a year, making it much more expensive to rent the property than it is to pay back your current mortgage of $100,000.

Second, consider how much your home may be worth in seven years’ time. If it is in a location that experiences significant capital growth during this period, your home could be worth well over $1 million. Remember, any capital growth an owner-occupied residence achieves is completely exempt from capital gains tax upon selling. By selling now, you will miss out on future tax-free capital gains.

Third, you’re right in thinking that your super fund earnings will be taxed at 15%. This may not seem like much of an impost if your fund is returning 20–30%.

However, these returns are extremely high and history shows that consistent returns at this level over a number of years are rare.

If the current sharemarket boom hits choppy waters and your super fund return begins to slide, you could significantly increase your risk. Not only could you end up with less retirement money than you bargained for in seven years’ time, but if you’ve sold your home to an investor, your rent payments could eat significantly into your retirement kitty.

I would encourage you to think things through very carefully and seek further advice before you make any decisions.

Apartment lifestyle

My wife and I bought an apartment which settles in June this year. We’re planning to move in about August, change our postal address, telephone number, etc, and live in the apartment for at least a few months.

If we don't like the apartment lifestyle, we will move back into our current home (which we have owned since July 1981). We don't want to rent it out, as we’re concerned about the risk of problem tenants who might damage the property.

If we like the apartment lifestyle, however, we will sell our current home. If we sell the apartment six months after settlement will we be liable for capital gains tax on any gain?

The property would have to have increased significantly during the time you held it to actually produce a capital gain. When working out your likely CGT liability, you need to work out the “cost base”. This includes the purchase price, purchasing costs such as stamp duty, and agent’s fees and advertising when you sell.

For example, if you purchase a property for $350,000 in Victoria, the stamp duty will be $16,660. When you sell you may pay the agent about $9000 commission and spend $3000 on advertising.

Therefore the cost base for CGT purposes is $350,000 $16,660 $9000 $3000 = $378,660. This means the property would have to grow by more than 8% to achieve a capital gain on selling six months later '” an extraordinary rate of growth given current market conditions.

So, while you may be liable for CGT, the amount is likely to be minimal.

Mark Armstrong is Director of Property Planning Australia, an integrated property advisory and mortgage sourcing service. He also writes for Australian Property Investor magazine.

You can email any questions regarding property to Mark Armstrong right here, by clicking questionmark@eurekareport.com.au