In the past, we have had discussions around “What Capital Gains Tax is and How Do You Calculate It?” This was an introduction to a three-part series on the different aspects of capital gains tax and key tax topics.
The follow up article, “Is There Capital Gains Tax on My Home or Business” delved more deeply into an area where a lot of people become confused when selling their assets which may have been used for income purposes.
In this third and final article on capital gains tax, I’m tackling a subject due to popular demand and because I want to share a secret that few investors know about: “How to Reduce Capital Gains Tax on Your Second Property”.
Capital Gains Tax on a Main Residence
You might remember from the previous articles that your main residence (i.e. your home) is generally exempt from capital gains tax, but there are a few caveats. Firstly, to receive the exemption, the property must have a dwelling on it, and secondly you must have lived in it. That means no, you’re not entitled to the exemption for a vacant block.
This is the best way to completely avoid your property’s capital gains tax however, it can only be utilised on one property per couple. A question that I get asked frequently is “How do I get the exemption for one property, and my partner for the other?” My answer (albeit, in jest) is that you need to get a divorce or a bona fide split up for good! This is not often the kind of answer people are looking for, and I certainly don’t offer counselling on the effects of this decision!
The truth of the matter is that it is very difficult to minimise any property Capital Gains Tax that results from the sale or disposal of a second property that is not a main dwelling for the owner, and even attempting to do so requires some care and consideration.
The three most important aspects to consider in reducing your capital gains tax on your second property are:
- Structure, structure, structure.
- Timing of the sale.
- Six year rule – a little secret for the family.
1. Structure, Structure, Structure
This is where the strategy begins. To choose the best structure for you we need to consider among many things the following main aspects:
- Your personal family structure
- Your age,
- You and your family’s income and the source of that income, and
- Your intentions for the second property, such as:
- Do you want to negatively gear the investment?
- Are you targeting revenue growth or capital growth in the investment property?
- Are you wanting to build wealth for your children?
Purchasing Under an Individual or Partnership
Property investments held under an individual or a partnership, give the benefit of the general 50% capital gains tax discount after you have owned the asset for a minimum of 12 months.
Under this model, if your second property is negatively geared (i.e. the rent received is less than the deductible expenses), a loss results which you can apply to your other income and reduce your tax for the year. If you receive only a wage or salary this can generally result in a nice income tax refund at tax time.
The disadvantage of holding your income (assets) in your own name or in a partnership is that a higher potential tax rate (on the capital gain) is applied, even after you apply the 50% general discount. The top marginal tax rate for individuals is a mammoth 47%!
I always find that using examples is the best way to illustrate the tax effects you’ll encounter in situations like this. We will build on this following example to help us compare between this and the other structures of ownership.
EXAMPLE OF PURCHASING AS AN INDIVIDUAL OR IN A PARTNERSHIP
Ken is married and has no children. He purchased a second investment property 20 years ago in 2001 in his own name for $500,000. Ken earns $200,000 pa. He wants to sell the property now to purchase a bigger home and sells it for $1,500,000, after receiving a valuation as such and after all selling costs. The property has always been break-even or slightly profitable. Ken has no prior year capital losses and has private health insurance.
The capital gain to Ken is $1,000,000 and the taxable gain is $500,000. The additional tax for this year will be $235,000. Ouch!
Purchasing Under a Unit or Discretionary/Family Trust
Purchasing a property in a trust has some significant advantages. Discretionary or family trusts have the added ability to choose the amount and the type of income to distribute to a beneficiary at the discretion of the Trustee. Unit Trusts must distribute in the proportion of the units held.
TOP TIP: It’s hugely important to ensure you use a tax professional to set up the family trust deed correctly to take advantage of this, otherwise all your plans could be null and void.
Trusts can also benefit from the same capital gains tax concessions as an individual.
Let’s look at the above example with Ken in an alternate universe to see the tax difference.
EXAMPLE OF PURCHASING UNDER A UNIT OR DISCRETIONARY/FAMILY TRUST
Ken is married with 2 adult children at the time of sale for the investment property. His partner earns $180,000 and the property was purchased under the Family Trust.
The capital gain is still $1,000,000 but Ken’s family trust distributes the taxable capital gain of $500,000 split between his 2 adult children. They each have no other income so the tax on their $250,000 is $88,167 so total tax on the capital gain for the family is now $176,334, a saving of $58,666. It’s almost worth having adult children!
Purchasing Under a Self-Managed Super Fund
The advantage of purchasing property under a self-managed super fund is that the tax rate is between 0% and 15%, however, beware! There are disadvantages. These disadvantages come in the form of strict limitations as follows:
- The use of the property – the property cannot be used for personal purposes at all. So, buying a property and hoping to enjoy it as a holiday home is not allowed
- The property cannot be leveraged other than direct borrowings on the property.
- The property cannot be developed, it must be income producing immediately.
- The ongoing cost of managing, auditing, and lodging returns can add up.
Let’s go back to our example owner Ken this time in a third alternate dimension to see if it’s worth it.
EXAMPLE OF PURCHASING UNDER A SELF-MANAGED SUPER FUND
Ken purchased the property when he was 50 in his Self-Managed Super Fund and he is now 70 years of age. He wanted to leave this property as his retirement investment and is ready to sell it now that he has reached retirement age. He places his self-managed super fund, which has $1.6 million of assets (including the current property value), into the pension phase. He then sells the property for a $1,000,000 Capital Gain. As the property is in Pension Phase, the complete gain of $1,000,000 is tax free. A saving of $235,000 is the result, compared to owning the property as an individual.
What a saving! Maybe the Self-Managed Super Fund option was worth it!
Purchasing Under a Company
Speaking in general, purchasing property under a company is not advisable from an accounting point of view. This is because the general 50% exemption after holding a capital asset for more than 12 months from the purchase to sale date is lost.
There are some circumstances where a company may have an advantage in holding property, however. One such example would be highly positively geared properties that have been held for a long period where the lower tax rate is beneficial, and the capital growth is limited. There are also some risk protection strategies with company structures. All that being said, I would still recommend seeking advice before buying property under a company name.
2. Timing of the Sale
Coming in second to the structure of your property is the timing around selling it. Careful and considerate planning will ensure you make the right decisions when selling a property. The catch is knowing when is and when isn’t the best time to sell a property in order to reduce your capital gains tax exposure. There are periods such as in times of a property slump, or vice versa, when the market may be running hot, where selling may not be best strategy available to you given your ownership structure and other income.
If you are aware that in 1-3 years’ time the taxable income of the owners of the property will be low or zero due to:
- loss of contract or,
- period of no revenue in the business due to development or restructure,
then it may be the ideal time to consider selling the property and realise the low tax environment of the beneficial owners.
It’s important in your annual tax planning that you share with your tax accountant your plans for the future.
3. Six Year Rule – Capital Gains Tax
What is the six year rule for capital gains tax? In a nutshell, the rule is that a property which was previously your main residence can continue to be exempt from capital gains tax.
Usually, a property stops being your main residence when you stop living in it. However, for capital gains tax purposes you can continue treating a property as your main residence.
So, how long do you have to live in a property to avoid capital gains tax in Australia?
- For up to 6 years if it is used to produce income, such as rent (this is what we mean when we refer to the “six year rule”).
- Indefinitely if it is not used to produce income.
During the time you treat the property as your main residence it continues to be exempt from capital gains tax, even if you rent it out in that period.
But, there is of course a caveat to this rule: the exemption is only available where no other property is nominated as a main residence for the taxpayer. But how does that work? We all need a place to live, right?
This is one situation where an example may be the best way to demonstrate the rule.
If you remember from earlier in the article, we said you can only have one main residence per couple unless you divorce. Well, there is a little secret I would like to share on getting the benefit of more than one main residence for your family without any emotional tragedy!
Many of our clients are concerned the volatile property price situation is causing their children to be squeezed out of the property market as they cannot afford to borrow due to study or just beginning their career. In addition, you may want them around home longer! Stranger things may have happened?
Rather than your young adult children waiting for an inheritance, as part of your estate planning, an opportunity exists to purchase a property (for example, a unit or a house) in your child’s name where they gain the first homeowner benefits that are offered in each state. After living in the property for a period, they can then rent the property out to a third party and live back at the family home to:
- save on living expenses,
- earn an income, and
- more importantly get a foothold in the property market while they study or build their career.
If they return to the property before six years’ time for another reasonable period, they can then rent it out again for a further six years.
By doing this once or twice in their life there are significant tax savings on purchasing the property with:
- first homeowner incentives,
- rent earned during the 6-year period/s of rent,
- and when the property is sold it is capital gains tax free!
The rental income can also be offset against any other allowable rent deductions and can include interest from the “Bank of Mum & Dad”, which means this estate planning strategy can provide a real return for all. Yep, a real win-win situation!
When it comes to Capital Gains Tax, it’s Best to Talk to the Professionals
Capital gains tax (indeed, taxes in general!) is an incredibly complex subject, that when handled incorrectly can cost you a mountain of money! That’s why it’s hugely important to make sure you contact a tax professional before making any property purchases or property sales.
At Bishop Collins, our experienced team of accountants know capital gains tax inside and out! And because ensuring our clients receive the support they need, we’ll provide you with a free 20 min consultation to cover everything about how you can reduce capital gains tax on your property. Just reach out to Bishop Collins Accountants and fill in our contact form at the bottom of this article.
Happy Property investing!