Capital Gains Tax - How Third Element Costs Might Reduce Your Capital Gain
In some situations it is possible for the expenses incurred while living in a property to be used to reduce your capital gain on sale.
It is something that I find even some accountants don’t consider.
So what is a third element cost and how would it help.
Let’s say Bob moves into an investment property (P1) that he owns and rents out his his current main residence (P2).
Bob sells P2 5 years later and decides to apply the six year absence rule to P2. So all good P2 is tax free.
But what happens to P1 ?
Well let’s use some simple calcs.
P1 was purchased on 1 July 2015 and was an investment property from that day.
Bob then moved into P1 on 1 July 2018 so 3 years later. He sells P1 on 1 July 2023
Because he elected for P2 to be his main residence under the 6 year absence rule then P1 (even though he was living in it for 5 years) he can’t elect for this to be his main residence.
So he will be subject to partial CGT. Time based calc. But since for the whole period it didn’t get a main residence exemption then the entire gain would be assessed. Ouch you say. Well maybe not.
Say the capital gain was $150k.
Bob also had interest costs while living in it of $20k per annum. So $100k in interest over those 5 years. Council rates of $10k over the 5 years. Building Insurance (not contents) of $3k over 5 years. Repairs of $15k over the 5 years. So total cost of ownership while living in it comes to $128k. These are what are called “third-element costs”
these reduce Bob’s gain to $22k. With the 50% CGT Discount it brings it down to $11k.
So Bob sells P2 tax free and pays a maximum $5k in tax on P1.
Not a bad result for Bob at all.
Frequently Asked Questions
What are third element costs in relation to Capital Gains Tax (CGT)?
Third element costs are expenses incurred while living in a property that can be used to reduce your capital gain on sale. These costs may include interest, council rates, building insurance (excluding contents), and repair expenses.
Can I apply third element costs to reduce my capital gain if I live in an investment property?
Yes, if you move into an investment property and incur certain expenses (interest costs, council rates, building insurance, and repairs) while living in it, these are considered as third element costs. They can be used to reduce the capital gain when you sell the property.
How does the six-year absence rule affect my main residence and investment property in terms of CGT?
If you move out of your main residence and rent it out, you can choose to apply the six-year absence rule. This means that the property can continue to be treated as your main residence for CGT purposes for up to six years. If you sell this property within this period, you won't have to pay CGT. However, if you live in an investment property during this time, you cannot designate it as your main residence, and it will be subject to CGT upon sale.
How are third element costs calculated in the example provided?
In the example, Bob lived in his investment property for 5 years, incurring $20k per annum in interest ($100k total), $10k in council rates, $3k in building insurance, and $15k in repairs over the 5 years. These expenses total $128k, which are considered third-element costs and are deducted from the capital gain to reduce the taxable amount.
What is the 50% CGT discount, and how does it apply in this context?
The 50% CGT discount is applicable for assets held for more than one year before the taxable event, and it allows you to reduce your capital gain by 50%. In the example, after deducting the third element costs from the capital gain, the resulting gain is further halved using the 50% CGT discount.