Key Terms:
- Gross Capital Gain: This is the difference between the sale proceeds (what you receive) and the cost base (your original purchase price and some additional costs).
- Cost Base: The total amount you’ve paid for the property—including the purchase price, stamp duty, legal fees, and other acquisition costs—plus any capital improvements. This figure forms the basis for calculating your capital gain or loss.
- CGT Discount: A 50% reduction on CGT for individuals, which is generally available if you have held the property for more than 12 months.
- Net Capital Gain: Your capital gain after accounting for any applicable apportionment and the CGT discount.
- Main Residence Exemption: A rule that can fully or partially exempt your primary home (Principal Place of Residence, or PPOR) from CGT. This exemption may be affected if part of your PPOR is used to generate income.
- Depreciation Adjustments: Deductions previously claimed on the property (for instance, for plant & equipment or capital works) that reduce your cost base and may increase your capital gain when you sell.
- 6-Year Absence Rule: A provision that allows you to treat your PPOR as your main residence for CGT purposes for up to six years after you move out, even if the property is rented out.
- Home First Used to Produce Income Rule: A provision which permits a reduced cost base at the point where a property which is currently exempt from CGT is first used to produce income.
- Deemed Acquisition: An ATO provision where an asset is treated as if it was newly acquired at its current market value when it first becomes income-producing. This means that instead of using the original purchase price as the cost base for future CGT calculations, the asset’s cost base is reset to its market value at the time it starts generating income. This adjustment ensures that any capital gain taxed upon eventual sale reflects only the appreciation that occurs after the asset begins producing income, rather than the entire gain since its original purchase
- Apportioned CGT Liability: The CGT liability resulting from using part of a primary residence to generate income.
- Balancing Adjustments: The treatment of PP&E assets upon the sale of a property.
A helpful way to think about the CGT calculation is to separate it into 3 parts:
1.
The CGT formula
- Cost base
- Depreciation adjustments
2.
Provisions that make a property exempt from the CGT formula
- PPOR exemption
- 6-year absence rule
3.
Scenarios that alter the CGT formula
- Converting your PPOR to an Investment Property
- Breaching the 6-Year Absence rule
- Renting a room or granny flat in your PPOR
The CGT Formula
The basic CGT formula is:
Capital Gain = (Sale Proceeds – Adjusted Cost Base) x CGT Discount
Where:
Sale Proceeds = Sale Price – Selling Costs
Adjusted Cost Base = Purchase Price + Acquisition Costs + Capital Works – PP&E Depreciation – Capital Works Deductions
Once the net capital gain (or loss) is successfully calculated, it is added to the owner’s taxable income in the financial year of the sale and taxed at their marginal tax rate.
Capital Works Deductions
The Cost Base is reduced by the sum of all capital works deductions claimed by the owner.
This is an important consideration for property investors, as you may elect to either:
1.
Claim the 2.5% capital works deductions each financial year in order to offset your personal income and minimise tax, or;
2.
Accrue the 2.5% each year and claim the entire sum when you sell in order to offset your capital gains tax on the property.
Depreciating Assets (PP&E)
If you sell depreciable assets (e.g. appliances) along with the property, you’ll need to apportion the sale proceeds between the property and these assets, as the tax treatment of the property and these assets are dealt with separately.
The ATO recommends using the Written Down Value (WDV) of the depreciable assets as a guide for apportionment, but you should confirm it reflects their current market value (as per ATO Taxation Determination TD 98/24).
1.
The current market value of the asset is subtracted from the cost base
2.
The difference between the WDV of the asset and the market value is added or subtracted to the Net Capital Gain
Example
A unit is purchased for $100,000 and a refrigerator is purchased for use by the tenant in the property at $5,000.
In the first year the refrigerator is depreciated at 16.67% (Effective life is 12 years).
Depreciation claimed in the financial year is $833.50 and the refrigeration opening WDV for the next financial year is $4,166.50.
The property was sold after 13 months of ownership for $200,000 including the refrigerator, the WDV of the refrigerator is $4,166 but the current market value of this model of second hand refrigerator is $2,000, leading to a $2,144 capital loss.
The property has a cost base of $100,000 (simplified) with $10,000 in purchase costs and $5,000 of sales costs.
- Cost Base = $100,000 + $10,000 + $5,000 = $115,000
- Sale price was $200,000 – $2,000 (market value of refrigerator) = $198,000
- Sales Price less Cost Base = Net Capital Gain: $198,000 – $115,000 = $83,000
- Net Capital Gain less Net Capital loss = $83,000 – 2,144 = $80,856
- Net Capital less 50% discount: $80,856 – 50% = $40,428 to be reported and taxed at owner’s annual rate for that financial year​
CGT exemption provisions
Primary Residences
Generally, a dwelling is considered your main residence if:
- You and your family live there.
- You keep your personal belongings there.
- It's your mail address.
- You're registered to vote there.
- You have utilities connected (gas, power).
- The length of stay and intention to live there are also considered.
Your main residence (home) is exempt from CGT if you meet all these conditions:
- You are an Australian resident.
- The property has been your home (including your partner and dependents) for the entire ownership period.
- The property hasn't been used to generate income (no business, rentals, or flipping).
- The property sits on land 2 hectares or less.
6-Year Absence Rule
The 6-year absence rule (section 118-145 of the ITAA 1997) allows you to potentially treat a former main residence as your main residence for CGT purposes even after you move out. However, there are limitations:
- The property can only be rented out for a maximum of 6 years while claiming the absence rule.
- You cannot choose another residence as your main residence during the same period.
The timing for the 6-year absence rule resets once you re-establish it as your main residence within the 6-year period, meaning theoretically you could continue to claim this exemption as long as you don’t claim any other property as a main residence in the mean time.
Scenarios adjusting the CGT formula
Converting your PPOR to an Investment Property
Whilst you can still take advantage of the 6-year rule to maintain a main residence exemption, converting your main residence to an investment property yields a few key considerations:
1.
Deemed Acquisition: For CGT purposes, the cost base of your property is reset to its market value at the time it first produces income. This means any capital gain accrued before conversion is essentially exempt, and only gains after conversion are taxable.
2.
Impact on Future CGT: After conversion, when you sell the property, you’ll be taxed only on the gain accrued post-conversion—subject to adjustments for any depreciation or capital improvements claimed thereafter.
Overall, converting your PPOR can lower your future CGT liability by effectively “resetting” the cost base, but it also requires careful planning regarding the rental period and subsequent tax implications.
Renting a room or granny flat in your PPOR
In addition to the income tax implications detailed in Lesson 6, opting to partially rent your PPOR results in the following CGT implications:
1.
Apportioned capital gain: The ATO will consider you liable for the % of the capital gain equal to the internal floor space (IFS) rented divided by the total IFS.
2.
Deemed Acquisition for the rented portion: If you convert your entire PPOR to a rental, then the whole property’s cost base is generally reset to its market value at the time it first produced income. However, if only part of your PPOR (such as a room or a granny flat) is rented out, then you must apportion the cost base. In that case, only the income-producing portion has its cost base reset to its market value at the time it first produced income, while the remainder retains its original cost base for CGT purposes.
Example
Imagine Alex owns a home of 200 square meters and rents out a 40-square-meter granny flat (20% of the total area). When the granny flat is first rented, its market value is determined (this becomes the deemed acquisition value for that portion). When Alex later sells the entire property, the capital gain on the 20% rented area is calculated using the deemed acquisition cost base, while the remainder of the property (80%) may continue to benefit from the main residence exemption. In this way, you’re only taxed on the gain that occurred from the time the granny flat became an income-producing asset.
Breaching the 6-Year Absence rule
If you keep your property rented out for more than six years without nominating another main residence, the exemption may no longer apply for the entire ownership period. Instead, you must apportion the capital gain between the period it was your main residence (exempt) and the period it was rented out beyond the six-year limit (taxable).
Example
If you owned your PPOR for 10 years and rented it out continuously after moving out in year 2, the first 6 years might be exempt, but the remaining 2 years’ portion of the gain would be subject to CGT.Â
This adjustment means that while the basic formula remains, your Adjusted Cost Base and Sale Proceeds must be apportioned based on the period of non-exemption.
1.
Deemed acquisition date = the beginning of the 6 years, according to the ‘home first used to produce income’ rule
2.
The adjusted taxable gain is calculated by multiplying the total gain by the fraction of time that exceeds the six-year threshold (2 years/10 years = 20%).
Complexities of granny flats and Main residence exemptions
In addition to the income tax implications of granny flats, further complexity is created if a granny flat is added to a property which is already subject to a partial CGT exemption.
Example
Dwelling acquired in 2007, established as MR on settlement in 2007, rented out in 2010 and the owner constructed a granny flat in 2018.
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Key Points:
- Granny Flat: The granny flat likely doesn't qualify for the main residence exemption because it's a separate structure.
- Separate Calculations: It may be necessary to calculate capital gains separately for the main house and the granny flat due to different rules applying.
- Unclear ATO Guidance: There's no clear guidance on how to handle the cost base for the granny flat's land.
Approach:
1.
Calculate separate gains: Treat the main house and granny flat as separate entities for CGT purposes.
2.
Apply "home first used to produce income" rule: Reset the cost base for the entire property to the market value in 2010 (first rental) and then apportion the gain.
3.
Calculate the partial MR exemption on the main house which may be available for the period the main house was occupied (2007-2010).
- "Absence rule" might allow exemption for the non-resident period (2010-2016), but only if no other main residence was claimed.
- After 6 years of rental (2016 onwards), only the gain from that period is taxable.
4.
Apply the Capital Gains Discount:
- The CGT discount (potentially less than 50%) might apply to the remaining gain after the main residence exemption, but only for the resident period.
5.
Cost Base Calculations:
- The cost base for the main house likely uses the market value in 2010 (first rental) due to the "home first used to produce income" rule.
- Granny flat's land cost base is unclear. Options include:
- Apportioning the original purchase price based on area.
- Arguing for the "home first used to produce income" rule and using the 2010 market value.
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We do not provide tax agent services. The information provided in this article should not be relied upon to satisfy liabilities or obligations that arise, or could arise, under a taxation law or to claim entitlements that arise, or could arise, under a taxation law. You should seek professional tax advice to understand your tax liabilities, obligations and entitlements.Â
