Previously we have discussed “What is Capital Gains Tax and How Do You Calculate It? This was an introduction to a three-part series on different aspects of capital gains tax.
The 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.
This final article on CGT, due to popular demand and because I want to share a secret that few investors know about, is “How to Reduce Capital Gains Tax on Your Second Property”.
Capital Gains Tax on a Main Residence
As a recap… Your main residence (your home) is generally exempt from CGT.
To receive the exemption, the property must have a dwelling on it, and you must have lived in it. WARNING: You’re not entitled to the exemption for a vacant block.
This is the best way to completely avoid CGT however, it can only be done one property per couple. I do get asked frequently “How do I get the exemption for one and my partner for the other?” My answer in jest is you need to get a divorce or a bona fide split up for good!
I don’t give counselling on the effects of this decision!
The second property is difficult to minimise any CGT that results from its sale or disposal and requires some care and consideration.
The three most important aspects to consider in reducing your CGT 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% CGT discount after you have owned the asset for 12 months.
Under this model if the second property is negatively geared (rent received is less than 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 refund at tax time.
The disadvantage of holding your income (assets) in your own name or in a partnership is the higher potential tax rate (on the capital gain) even after you apply the 50% general discount. The top marginal tax rate for individuals is 47%!!!
Examples are the best way to illustrate the tax effects. We will build on this example to help us compare with 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 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/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.
IMPORTANT: Ensure you use a tax professional to set up the family trust deed correctly to take advantage of this.
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 time of sale of the investment property. His partner earns $180,000 and the property was purchased under the Family Trust.
The capital gain is still $1Million 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 advantages of purchasing property under a SMSF are that the tax rate is between zero and 15% however there are disadvantages. There are 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 are 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.
But let’s see if it’s worth it.
EXAMPLE OF PURCHASING UNDER A SMSF
Ken purchased the property when he was 50 in his SMSF and he is now 70 years of age. He wanted to have this property as his retirement investment and is ready to sell it. He places his SMSF, which has $1.6 million of assets (including the current property value), into the pension phase. He then sells the property for a $1million 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 as an individual. Maybe the SMSF option was worth it!
Purchasing Under a Company
Generally purchasing property under a company is not advisable as the general 50% exemption after holding a capital asset for more than a year on sale date is lost. There are some circumstances where a company may have an advantage in holding property such as highly positively geared properties 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 however generally I would still seek advice before buying property under a company name.
2. Timing of the Sale
Second to structure is timing. It’s the work of planning that will ensure you make the right decisions when selling a property. The catch is when is and isn’t the best time to sell a property to reduce your capital gains tax exposure. Such as in times of a property slump, or vice versa, the market may be running hot, such as the current climate, and selling at this time may not be best 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 a good time to consider selling the property and realise the low tax environment of the beneficial owners.
It’s important in your annual tax planning you share with your tax accountant your plans for the future.
3. Six Year Rule – A Little Secret for the Family
There’s a special six-year rule, which means 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 CGT purposes you can continue treating a property as your main residence:
- for up to 6 years if it is used to produce income, such as rent (sometimes called 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 CGT, even if you rent it out.
The exemption is only available where no other property is nominated as a main residence for the taxpayer.
Let’s apply this to live examples…
Above, 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 high and rising 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 longer!
Rather than your young adult children waiting for an inheritance, as part of your estate planning, an opportunity exists to purchase a property (unit or house) in your child’s name where they gain the first homeowner benefits 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 6 years’ time for another reasonable period, they can then rent it out again for a further 6 years.
By doing this 1-2 times 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 MUM & DAD BANK so this estate planning strategy can provide a real return for all.
I encourage you to make sure you contact a tax professional before making any property purchases or property sales. We would be happy to provide a free 20 min consultation to cover these aspects generally. Just reach out to Bishop Collins Accountants and fill in our contact form at the bottom of this article.
Happy Property investing!
Please note, I do not cover Land Tax in this article as each state has its own regulations.