Owning a second property can pay handsomely but is fraught with its own set of financial responsibilities, one of them being the payment of Capital Gains Tax. When you sell a property that is not your residence, you could fall prey to paying CGT on the profits. Under law, however, you can minimise or even nullify this impediment.
Throughout this guide, we’ll break down:
- What CGT is
- What exemptions are available
- How to reduce CGT payable on the second property
Understanding Capital Gains Tax (CGT)
Capital Gains Tax is that tax paid on the profit of an asset in the form of a second property. The tax comes into play on the differential value between the sale price and the purchase price, coupled with expenses and improvements.
In Australia, CGT isn’t a separate tax; it’s part of your income tax. You will include any capital gains in your assessable income for the year you sell the property. Your marginal tax rate determines the amount of CGT, so it’s essential to seek ways of minimising this liability.
Primary Residence Exemption
The easiest way to avoid paying CGT is by using a primary residence exemption. The property you are selling has to be your main home; that’s when you can usually claim exemption from paying CGT. At the same time, this cannot be applied in case of second properties, so this rules out investment properties.
Temporary Absence Rule
If you move out of your primary residence and rent it out, you can still claim it as your main residence for up to six years under the temporary absence rule. This means that you won’t pay CGT if you sell it in this period provided you do not nominate another property as your main residence.
Using the Six-Year Rule for Investment Properties
The six-year rule is considered one of the most potent weapons in the armoury of the investor who turns their main residence into an investment property. Here’s how it works.
- Declare the Property as Your Main Residence: The ATO says that you need to have lived in the property as your main residence before you start renting it.
- Rent Out the Property: You can rent it out for up to six years and still claim it as your main residence.
- Sell in Under Six Years: If anything of a sale nature occurs in the six-year period of that property, then no CGT.
You keep moving in to reset the clock for a six-year timeframe every time you go.
Partial Exemptions
These arise whenever you live in a property part of the time and then rent it for the remainder of the period. Again using our earlier example, had you lived in the property for five years and let it for the remaining five years of the period in which it sold, you will have to pay tax on half the gain.
Leveraging Capital Losses
The capital losses from these other investments can offset your capital gains, hence reducing your CGT liability. Here’s how you may apply it to your benefit:
- Sell Underperforming Assets: Sell some of your underperforming shares or other investments that have lost value. In this case, you can create a capital loss.
- Offset Gains with Losses: Offset the gain you get from your property sale with the capital loss. The amount of your taxable capital gain is reduced.
Unused capital losses can be used in future years, providing ongoing tax benefits.
Time the Sale
The timing of your property sale can significantly affect your CGT liability. Consider the following strategies:
- Sell in a Low-Income Year: Where you anticipate a low-income year – for example, you retire or change careers – the timing of that sale in that year may reduce the CGT, because your marginal tax rate will be low.
- Spread the Sale Over Two Financial Years: Subject to the particular circumstances allowing it, this spreads the sale over two financial years and spreads the capital gain over two tax periods, assuming that your marginal tax rate is lower.
Investing in Superannuation
Investment of the proceeds from the sale into superannuation could be another option in managing CGT in a tax-effective manner. Australia has tax concessions for superannuation in place that may reduce the overall effect of the tax.
Downsiser Contributions
If you are older than 55 and sell your home, you can use your sale proceeds to make a downsizer contribution to your superannuation of up to $300,000 per person ($600,000 for a couple). This does not count toward your normal contributions cap, and hence, it essentially means a substantial tax saving.
Keeping Accurate Records
Good record keeping of your capital gains transactions is key to this process. This should include the following.
- Purchase Price: Retain records showing original purchase price.
- Expenses: Record all expenses in:
- Acquiring
- Improving
- And disposing of the property
- Rental Income and Expenses: All rental income, with its associate expenses.
Accurate records will enable you to claim all the deductions available and correctly calculate your capital gain or loss.
Consulting a Tax Professional
While these following tips can either reduce or avoid CGT, the taxation laws are complex and continually changing. It is strongly advised to engage the services of a tax professional or accountant who can ensure you comply with any current legislation and access all concessions available.
Additional Strategies to Minimise CGT
In addition to the more common practices available, other strategies will even further reduce your CGT position:
Pre-Sale Property Improvements
Any improvement made prior to the sale of your property which enhances its value will have the effect of increasing the cost base and reducing the capital gain.
Examples of such improvement would include:
- Renovations
- Extensions
- Major repairs
These must be documented in great minute detail, including receipts and invoices.
Small Business CGT Concessions
If you run a small business and the property has formed part of the business use, then you will qualify for CGT small business concessions. These may enable you to reduce or, in some cases, eliminate, CGT. The main concessions available in these circumstances are:
- 15-Year Exemption: An exemption if you had held the property for at least 15 years and are retiring or permanently incapacitated.
- 50% Active Asset Reduction: If the property was used in the course of business, you get a 50% reduction in the capital gain.
- Retirement Exemption: An exemption for up to $500,000 of capital gain upon your retirement.
- Rollover Concession: You can defer the capital gain by rolling it into a replacement asset.
Defer Sale Until Retirement
When you sell out after your retirement, your income and, therefore, your marginal tax rate may fall; you would, then, potentially pay less CGT. In addition, retirees can access other tax concessions that would further reduce their tax payable.
Family Trusts
If the property is held in a family trust, the trust is allowed to distribute income, which includes capital gains, to beneficiaries in low tax brackets, hence substantially reducing the overall tax liability. This again requires proper planning and strict adherence to regulations on trusts.
Conclusion
Exemptions in paying Capital Gains Tax on a second property in Australia require quite a good amount of planning and a clear understanding of the tax exemption laws. You will be able to reduce your CGT by:
- Leveraging exemptions
- Timing your sale strategically
- Using capital losses
- Making superannuation contributions
Always remember to keep complete records and consult with professionals for the best possible advice on taxation and the realisation of full benefits from this investment in your property.
