Turning your home into an investment property could be the easiest way to start your investment journey. However, there are traps you need to be aware of, especially if you decide to move back in again. Eddie Chung explains
Life is unpredictable and change is just about the only thing that is constant. For one reason or another, many people find themselves having to move out of their existing home. To maximise their financial return, they may rent their home out and either rent a new property as their residence or buy a new home.
It should come as no surprise to anyone that the owner must declare any rental income derived on the previous home as assessable income in their tax return, but any expense they incur in relation to the property can be claimed as a tax deduction to the extent that the relevant expenditure is not capital, private, or domestic in nature; any capital expenditure incurred may also qualify for the capital works or depreciation deductions.
However, depending on the specific circumstances, there may be further taxation consequences associated with the arrangement that may not always be obvious.
No new home is purchased
Under the default capital gains tax (CGT) rules, if you rent out a property for a period during your ownership of it and you eventually sell the property, you may have to pay an apportioned CGT liability, which is prorated based on the time the property was producing income relative to the entire period during which you owned the property. The underlying tax policy behind this apportionment requirement is that while you were using the property as your ‘main residence’, no CGT should apply.
However, a number of special rules apply that may override the default rules. If you do not apply the special rules correctly, you may find yourself overpaying CGT or paying an incorrect amount of CGT.
Potential Pitfalls
1. Failure to apply the ‘temporary absence rule’.
Under this rule, provided that the property used by you as your home when it was purchased, just because you have rented it does not automatically mean the property will lose its main residence exemption immediately for CGT purposes.
The ‘temporary absence rule’, in these circumstances, will allow you to continue to treat the property as your main residence, provided that you do not own another main residence elsewhere. As a general rule, you and your spouse can normally only treat one property as your main residence, subject to limited exceptions, eg if you separated or you are in between homes.
If you rent out the property, you can continue to treat the property as your main residence for up to six years. If you do not rent out the property at all, it can continue be your main residence indefinitely.
Further, if you move back into the property just before the six years expire, live in it as your home and vacate it again, the temporary absence rule effectively allows you to 'stop the clock’ and you are entitled to another six years if you rent the property out again.
Therefore, if you fail to apply the temporary absence rule and pay CGT by straight apportionment, you will be overpaying CGT.
2. Temporary absence rule is applied but the CGT is incorrectly calculated because the incorrect ‘cost base’ is used to calculate the CGT.
Under the general CGT rules, a capital gain is usually calculated as the sale price less the cost base of the property before any applicable capital loss offset and/or CGT discount. However, a ‘special acquisition and cost base rule’ applies if the following conditions are satisfied:
- You would only have been entitled to claim a partial main residence exemption on the property because it was used to produce income during your ownership period on or after 20 August 1996; and
- You would have been entitled to a full main residence exemption on the property if the property was sold just before it first started producing income.
If these conditions are satisfied, you are deemed to have acquired the property at its market value when the property first started producing income. To this end, you will need to obtain a valuation at that time to ensure that the cost base of the property is correct if the property is sold and you need to calculate the CGT on the sale.
For instance, assume that you originally bought a home for $500,000 and lived there for two years (after 20 August 1996); the property was then rented out for eight years and sold for $800,000. When the property was first rented out, the market value of the property was $550,000. You never bought another property.
If you are not aware of the special acquisition and cost base rule, you would have calculated the capital gain as $800,000 – $500,000 = $300,000 (disregarding any potential CGT discount).
However, as the property was rented for more than six years, you would only have been entitled to claim a partial main residence on the property and, had you sold the property just before it started producing income, you would have been entitled to a full main residence exemption, and the special acquisition and cost base rule would apply. Accordingly, the capital gain should have been calculated as $800,000 – $550,000 = $250,000.
In other words, if the property has increased in value since you originally bought it and you use the original cost base to calculate the CGT, it is likely that you will be overpaying CGT.
3. Incorrectly performing the apportionment calculation even if you apply the temporary absence rule.
As mentioned above, if you temporarily vacate your home and do not purchase another home elsewhere, you may continue to treat the property as your main residence for up to six years if the property is rented out. However, you will also need to take into account the special acquisition and cost base rule if it applies. Given the complexity involved in respect of the interaction of these rules, it is not uncommon for people to miscalculate the apportioned CGT.
By way of an example, consider the following scenario:
- You bought a main residence after 20 August 1996 and lived there for two years;
- You then rented the property out for eight years;
- You moved back into the property for another three years;
- You sold the property immediately after the three years; and
- You never bought another property.
= 13 years and the main residence exemption period of 2 + 6 + 3 years = 11 years.
Therefore, the ‘apportionment factor’ you would have used is 11/13 (ie 84.62%).
However, the special acquisition and cost base rule applies because you would only be entitled to a partial main residence exemption as the property was rented out for more than six years, and the property would have qualified for the full main residence exemption if it was sold immediately before it was rented out.
Accordingly, given that you are deemed to have acquired the property after the initial two years, your entire ownership period of the property for the purpose of the apportionment calculation should be:
The main residence exemption period should be 6 + 3 years = 9 years.
Therefore, the correct apportionment factor you should have used is 9/11 years (ie 81.82%).
For completeness, the special acquisition and cost base rule will apply such that the market value of the property when the property first produced income will need to be used as the cost base for the CGT calculation.
On the other hand, if the facts are slightly different as follows, an entirely different outcome may arise:
- You bought a main residence after 20 August 1996 and lived there for two years;
- You then rented the property out for five years only;
- You moved back into the property for another three years;
- You sold the property immediately after the three years; and
- You never bought another property.
A new home is purchased
If you turn your existing home into an investment property and buy another home elsewhere, as a general rule the existing home will cease to be your main residence once you stop living in it. There is a misconception out there that youi can pick one of the properties and treat it as your main residence, eg you may continue to choose the property that has now become an investment property as your main residence because you are of the view that this property may accrue a larger capital gain over time.
However, contrary to this common misconception, the law provides that a property may only be regarded as your main residence and qualify for the main residence exception if you and your family live in it as your home, which is a question of fact and turns on evidence such as the address you hold out to the public as your postal address, whether the property is the address you use for the electoral roll, etc. Therefore, if you keep both properties and move out of the original one, your previous home will case to be your main residence and will not be eligible for the temporary absence rule (because you have purchased another main residence) and your new home will become eligible for the main residence exemption going forward.
Conclusion
The main residence exemption rules appear simple in theory, but complications may arise in real-life situations, especially where those situations are less than straightforward. Therefore, care must be taken to apply the main residence exemption correctly to ensure that you are paying the correct CGT on the eventual sale of the property.
Eddie Chung is partner, tax & advisory, private clients, at BDO (QLD) Pty Ltd
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. The article is provided for general information only and the author and BDO (QLD) Pty Ltd are not engaged to render professional advice or services through this article. The author and BDO (QLD) Pty Ltd expressly disclaim all and any liability and responsibility to any person in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this article.
This feature is from the October issue of Your Investment Property Magazine. Download the issue to read more!
