Subdividing property, tax and negative gearing

Summary: Strategies for subdividing your block and negatively gearing a rental property, and situations where capital gains tax kicks in when a property is transferred upon death. 

Key take-out: The demolition-subdivision trick doesn't always work from a capital gains tax (CGT) perspective.

Question: I am 65 years of age, still working full time, married with my wife, who's not working. We are about to demolish our home of 23-years, subdivide and build two new two-story homes on our existing subdivided block. Could you tell me if what I read on the ATO website is correct, in that if we live in one of the homes for three months after completion, sell it, then live in the other house, we are not liable for any CGT?

Answer: Unfortunately what you have read on the Ausrtalian Tax Office website could not be further from the truth. In fact, there is another part of the ATO website that states the following:

‘The profit from selling subdivided land may be a capital gain or ordinary income, depending on the circumstances. However, any profit is treated as ordinary income (not a capital gain) if both of the following apply:

• your intention or purpose in entering into the transaction was to make a profit or gain
• you entered into the transaction, and the profit was made, during carrying on a business or carrying out a business operation or commercial transaction.

What this advice from the ATO means is that not only could the profit made on the sale of the house you live in for three months be taxable but could also be regarded as ordinary income since you would pay tax on all of the gain made without the benefit of the 50 per cent capital gains tax reduction.

In addition, as you would be selling a new house that is subject to GST, one 1-11th of the selling value of the house you live in for three months would have to be paid to the ATO, after taking account of the GST paid on any costs of building the house.

I have had many clients in this situation over the years. In these situations, if it is practical to do so, it's better to subdivide the property with the existing residence in place, build a new house on the subdivided part of the block, sell the existing residence, and then move into the new house.

This means that all the gain on the sale of the original residence is capital gains tax free, as long as the sale of the existing residence is made after July 1, 2018 you could be eligible for making a $300,000 downsizer contribution, and then your new house would receive the benefit of principal residence CGT exemption.

Before taking any action, you should speak to a professional that specialises in strategic tax planning, because if you get this wrong you could see a high percentage of the cash generated from the subdivision disappearing in not only income tax but GST.

Question: We are thinking of subdividing our property and building two homes. One we would live in and keep the other as a rental. Can we negative gear the rental property?

Answer: What you are proposing not only makes sense from making a negatively geared rental property investment, but also can get over the income tax and GST problems outlined in the first question.

The process that you would need to go through would be to apportion the original cost of the property, plus any of the subdivision costs, between the two blocks. You then need to keep a record of all costs related to the house that you plan to rent, with all of these construction costs being funded by the loan. If you sold or were forced to sell the rental property in under five years you could find that GST would be payable on the sale proceeds.

For the negative gearing to be worthwhile you would need to be earning sufficient taxable income that the negative gearing loss could be used to reduce. In other words, the tax benefit of a negative gearing loss is limited to the marginal tax rate that is paid on the income earned in a year.

For example, if the loss reduced the taxable income of someone whose income before the loss was between $37,000 and $87,000, the benefit received would be a tax reduction at 34.5 per cent of the negative gearing loss.

You might also want to consider a strategy I sometime use for clients. Under this strategy one of the houses is built with the idea of the client shifting into it at some time in the future. This property would be rented while the client lives in the other house.

At some time in the future, possibly when the client intends to retire after turning 65, their residence is sold, the loan on the house that has been rented is paid out, and as long as they have lived in the home they are selling for at least 10-years, up to $300,000 each of the surplus sale proceeds could be made as downsizer super contributions.

Before deciding on what action to take you should seek professional advice.

Question: I bought an investment property in 2009 and I will leave this to my children when I die. Do my children have to pay capital gains tax when that property is transferred to them under my will, and does the capital gains tax only apply if the property is sold and the proceeds exceed the cost of the property? Do things change if my children live in this house permanently?

Answer: When the ownership of a property is transferred as a result of someone dying and the new owner inherits that property no capital gains tax is payable at that time. If the property had been the person's home or dwelling and is sold within two-years of the date of death no capital gains tax is payable.

If a property had always been used to produce rental income and was purchased before September 1985, and the new owners continue renting the property and then sell it, capital gains tax will be payable on the amount that the sale proceeds exceed the value of the property at the date of the death of the original owner.

If the rental property was purchased after September 1985, as is the case in your situation, rented by the new owners and then sold, capital gains tax will be payable on the amount that the sale proceeds exceed the purchase cost of the original owner.

If a rental property ceases to be rented after the death of the original owner, the new owners inheriting the property shift in and it becomes their main residence, no capital gains tax is payable when the property is sold.