Mastering Capital Gain Tax Investment Property: Strategies to Minimize Your Bill

Understanding Capital Gains Tax on Investment Properties

Determining Cost Base and Capital Gain

Your property’s cost base includes:

• The purchase price
• Incidental costs, including legal fees, stamp duty, and real estate agent’s commissions
• Capital expenses, like conveyancing costs, stamp duty, and legal fees incurred during the purchasing and improvement of the property

You can add these costs to your property’s cost base.

Maintaining detailed records of all expenses related to your property’s purchase, improvements, and sale is critical for accurate determination of the cost base for CGT calculations. The capital gain or loss is the difference between the property’s cost base and the amount received upon disposal, requiring a precise calculation of the cost base and understanding of sale proceeds.

Different Calculation Methods

In Australia, you can calculate the CGT using one of three methods: the ‘Other’ Method, the Discount Method, or the Indexation Method. The Indexation Method is relevant for assets acquired before 21 September 1999 and held for at least 12 months, enabling the cost base adjustment for inflation up to that date. You can calculate the indexation factor using the Consumer Price Index by dividing 68.7 (CPI for 30 September 1999) by the CPI when the cost was incurred and adjust the cost base of eligible expenses accordingly.

The decision between the Discount and Indexation methods depends on factors such as the asset type, ownership period, historical inflation rates, and existing capital losses. If you’re using the Discount Method, capital losses are deducted from capital gains prior to the application of the CGT discount.

The ‘Other’ method, a straightforward calculation of CGT, is used when the asset was owned for less than 12 months by subtracting the cost base from the capital proceeds.

Factors Affecting CGT Calculation

For co-owners of an investment property, CGT outcomes differ and depend on each co-owner’s stake in the property. Properties acquired before 20 September 1985 are exempt from CGT except for certain capital improvements made after that date. The ATO may consider the intention behind the purchase of a property when determining CGT, particularly if it was always meant as a rental investment. Your residency status during property ownership and at the time of sale influences CGT calculations and eligibility for exemptions.

CGT events are triggered in the following situations:

• When a property is lost or destroyed, occurring at the time of the first insurance payout or compensation receipt, or at the time of the loss if there’s no insurance.
• Trusts and super funds may be eligible for discounts.
• Companies cannot access the CGT discount.

The cost base for CGT calculation does not include costs that can be claimed as a tax deduction, such as capital works deductions.

The net capital gain, after discounts and loss offsetting, is added to an individual’s taxable income and taxed according to their marginal tax rate.

The 6-Year Rule

Under the ‘6-year rule’, an investor can classify a rental property as their main residence for CGT purposes for up to six years following its initial rental, possibly granting it a CGT exemption during this timeframe. To qualify for the 6-year rule, the property must have been established as the investor’s main residence prior to being used to generate rental income, and the owner must no longer reside in the property.

If the property is rented out for more than 6 years, it will be subject to CGT after the 6-year period, with the cost base being the property’s market value at the initial rental date plus any applicable costs incurred subsequently. However, if the property is not used to produce income after being vacated, it maintains its status as the main residence for CGT purposes indefinitely unless another property is designated as the main residence.

The ATO offers a partial exemption for a property that has served both as a rental and a main residence. This is done through the ‘Years Lived In vs. Years Rented’ calculation, adjusting CGT according to the duration the property functioned as each. If the property was used to produce income while simultaneously being used as the main residence, only a partial main residence exemption may apply, potentially increasing the CGT liability.

The 50% CGT Discount

Australian residents for tax purposes who have owned assets for at least 12 months prior to selling can avail the 50% CGT discount. Individuals and trusts can avail a 50% discount on CGT, whereas complying superannuation funds receive a 33.33% discount. However, companies are not eligible for any CGT discount.

For assets acquired before 21 September 1999, indexing the cost base for inflation is an alternative to obtaining a CGT discount, but both benefits cannot be combined. Investors in affordable housing who offer rental properties to low or moderate-income tenants for at least 3 years can receive an additional 10% CGT discount, totaling a 60% discount.

Inherited assets from deceased estates and assets transferred due to relationship breakdowns can have their previous ownership periods considered towards meeting the 12-month ownership requirement for the CGT discount. However, foreign or temporary residents are generally not eligible to claim the full CGT discount for capital gains made after 8 May 2012.

Payment Deadlines and Penalties

Note that if the CGT payment due date falls on a weekend or public holiday, payments can be made on the subsequent business day without attracting a penalty.

Also, failing to pay any owing land tax on an investment property before selling it can result in financial or legal penalties.

Required Documentation

Maintaining accurate records is crucial when dealing with CGT. Here are some important points to remember:

• The time of a CGT event, which is crucial for tax purposes, is determined by the contract of sale date rather than the settlement date.
• The ATO mandates that individuals retain detailed records related to CGT events for at least 5 years.
• All records kept for CGT purposes must be in English or easily translatable into English.
• Records should clearly outline the nature, date, participants, and relevance of the transactions to capital gains or losses.

For tax reporting and consultations with tax advisors, you should collect all pertinent documentation, including property management records, purchase and sale contracts, and records of expenses. Keeping accurate records of both capital gains and losses is essential for investors, as these records enable the strategic use of losses to offset capital gains for tax minimization.

Deductible Expenses

As a property investor, you can claim tax deductions on expenses related to your rental property, including:

• Interest on investment home loans
• Any associated loan fees
• Repairs and maintenance expenses (when they are for restoring the item to its original condition and do not represent an improvement)
• Depreciation of both the building structure and features of a rental property (a depreciation schedule prepared by a Quantity Surveyor is required for this purpose)

Additional deductible expenses for property investors include:

• Advertising for tenants
• Strata fees
• Council rates
• Utility bills
• Property management fees
• Some legal fees
• Stationery
• Travel costs
• Land tax
• Pest control

Impact on Capital Gains Tax

Expenses incurred to generate rental income can decrease the investment property’s cost base, potentially raising the taxable capital gain. Claiming expenses related to a rented portion of a PPOR, like a granny flat, can affect the overall CGT when the property is sold. The cost base of a property does not incorporate amounts that have been claimed as tax deductions, such as capital works deductions and decline in value deductions, influencing the CGT calculation upon sale.

For properties located overseas, CGT calculations are based on the property’s market value at the time the owner became a tax resident of Australia if the sale happens while they are non-residents for tax purposes.

Finding the Right Advisor

When seeking advice on property investment, it’s vital to choose a professional with extensive experience and a proven track record across several property cycles. A good property advisor will focus on long-term financial goals, remove anxiety by simplifying complex concepts, and ensure their clients understand the risks as well as the rewards of property investment.

The relationship with a property advisor should be long-term, with regular reviews of property portfolio performance to ensure alignment with financial objectives.

Preparing for Consultation

Ahead of the consultation, it’s important to gather all necessary financial records, including purchase and sale contracts, expenses records, and details of any capital improvements to the property. Knowledge of various investment strategies such as buy-and-hold, flipping, or utilizing a property as a short-term rental can have different tax outcomes, and understanding these can enhance the productivity of the consultation.

Presenting a clear picture of one’s personal financial situation, including income, expenses and financial goals, allows the tax consultant to provide more precise and beneficial guidance.