REVENUE OR CAPITAL ACCOUNT
The first question to ask is not how much capital gains tax you will pay but rather is it subject to the capital gains tax regime or the revenue (ordinary income) regime. Some people have referred to it as being regular income. It’s not a term I like but have heard regular income being used before.
Huh? What does this mean?
There are basically three ways that a property sale might be taxed
1. Business of Property Development
2. Profit making undertaking or scheme
3. Mere realisation of a capital asset.
This distinction is quite important as it can impact on a number of things including
1. Whether the CGT Discount applies. this is sometimes known as the 50% capital gains tax discount and applies to a long-term capital gain (basically assets held for more than 12 months).
2. Whether the Main residence (“family home”) exemption applies
3. Pre CGT assets
4. Capital losses
5. Small business concessions
7. Timing issues
This is going to determine whether you will pay capital gains taxes. But we frequently have clients ask “what capital gains taxes” will i be paying. Capital gains tax isn’t actually a separate tax but rather you work out what the capital gain is, and this is added to your other assessable income.
This is an area that the Australian taxation office has high on their audit activity list.
This is a difficult area of the tax laws, and I will try to explain it as simply as possible but even the simple explanation is sometimes complex.
As a tax barrister once said to me “facts matter” and when you start to undertake any type of development on your property or land the facts really do matter.
The most common question I get asked when someone has a block of land or has a house that they have held for a while is “so tell me how much capital gains tax I will pay”
It’s a fair question for those who don’t spend their days analysing tax legislation and cases but for those of us who do the first question always is “so tell me what your original intention was”
The intention and changes in that intention over time can lead to very different tax outcomes.
Now the reason this is important for many people is that if the profits on sale are taxed on what is known as capital account, then the net capital gains can be discounted by 50% and that 50% taxed.
However, once the profits on sale are treated as being on what is known as revenue account then the 50% capital gains tax discount is no longer available. That can hurt particularly if the property is held in individual names, and they are earning other income.
The difference in outcomes can be illustrated below
Things that you will need to consider when making which of those potential three categories and whether capital gains tax will apply include
1. Intention when the assets held
2. Reason for doing the works
3. Location of the property
4. Previous use of the property
5. Any previous attempts to sell and why they might have failed to sell
6. Any steps taken to initiate rezoning or development activities and who initiated those steps
7. The level of development works and activities
8. The amount of risk the owner has taken
9. The cost of the development vs the value of the property
10. Previous history of other activities the person has undertaken
11. The extent of involvement in the activities
12. The level of borrowed funds and where those funds have come from.
As you can see its quite an extensive list of things to consider !!
Peter owns an industrial property on a large block of land. When Peter purchased the property, he did so as part of a strategy of holding the asset long term to generate rental income.
The council has recently rezoned the area in which the industrial property is located to allow for high rise residential housing.
Peter is also undertaking a significant development as an investor with another business partner and funds are needed to fund that particular development.
Peter operates a number of cafes in the Melbourne area. A developer has approached Peter to purchase his industrial property.
If we look at this example a few things arise
1. The sale of the industrial property is outside the course of Peter’s business.
2. Peter’s intention was to hold the property for the purpose of long-term leasing and not profit making by sale.
3. Peter did not approach council for rezoning but was part of a wider council strategy for the area.
4. Peter will be doing no works to the property prior to sale.
Based on these it would be reasonable to assume that the sale of the industrial property by Peter would be a mere realisation of his asset and it would be treated on capital account and if held in his own name or a trust then the net capital gains eligible for the 50% CGT Discount.
So, let’s assume you have now worked through things and determined that yes you will possibly have to pay capital gains tax what are the steps involved?
Determine if there has a capital gains tax event during the year and the time of the event. For the sale of property on capital assets held the event is generally the contract date for a disposal or the date the capital asset was destroyed.
This will be important as the capital gain will be reported in the income tax year that the capital gain or capital loss arises.
Determine when the capital asset was acquired and the period that the asset was held (this is known as the ownership period)
Determine if the gain is exempt from capital gains tax and therefore no need to calculate a capital gain or loss
Examples of this could include
– main residence exemption
– the property was acquired before 19 September 1985 (but be careful can be some traps here)
Calculate your capital gain.
The net capital gain is included in your income tax return as assessable income.
HOW TO CALCULATE CAPITAL GAINS TAX ?
There are some important things to consider when calculating your capital gain.
The first thing is the ‘cost base’
So, what is the cost base you ask?
It is made up of five elements.
the money you paid, or are required to pay, in respect of the acquiring the asset; and
the market value of any other property, you gave, or are required to give, in respect of acquiring it.
incidental costs you incurred.
the cost of owning the CGT asset you incurred. These costs include
interest on money you borrowed to acquire the asset ; and
costs of maintaining, repairing or insuring it l and
rates or land taxes, if the asset is land; and
interest on money you borrowed to refinance the money you borrowed to acquire the asset; and
interest on money you borrowed to finance the capital expenditure you increased to increase the assets value.
capital expenditure you incurred
capital expenditure you incurred to establish, preserve or defend your title to the asset or a right over the asset.
With all elements of the cost base keeping accurate records is critical as during an audit you will be asked to substantiate your calculation.
WHAT HAPPENS TO ALL THE INITIAL COSTS ?
Obviously the first expenses you will have when you purchase an investment property are things such as the actual price you paid for the property, stamp duty, legal expenses, etc.
A common question we get asked by clients is what happens to all those expenses you paid up-front?
We will go through each of the expenses you have when you purchase an investment property and outline what happens for tax purposes.
The purchase price is obviously the largest cost. This is not a tax deduction, but it is a first element cost. What this means is that it is used to calculate the capital gain or capital loss you make when you eventually sell the property.
This cost is included in the ‘cost base’.
If the stamp duty relates to a lease, then the expense is tax deductible. Section 25-20 ITAA 1997 provides a deduction for the costs of preparing, registering or stamping a lease of a property where the property is used solely for the purpose of producing assessable income. For example, in the Australian Capital Territory (ACT) a lot of the land is on a crown lease and therefore the “stamp duty” paid on the purchase of property in the ACT will in all likelihood be a tax deduction as it relates to the cost of preparing a lease on Crown Land which is granted for definite period of time
Legal Fees and/or Conveyancing fees
This cost is included in the ‘cost base’. It is not tax deductible.
If the legal expenses related to reviewing loan documents or specifically related to the loan documentation, then this would be deductible as borrowing expense
Real Estate Agent Commissions
This cost is included in the second element. It is not tax deductible
Building and Pest Inspection Reports
This cost is included in the second element. It is not tax deductible.
Claiming the stamp duty paid on transfer as a tax deduction where the property is not a crown lease.
Claiming borrowing expenses in the first year rather than apportioning them.
If the loan has a private component and investment component not making an adjustment to the borrowing expenses for the private component
CALCULATING YOUR CAPITAL GAINS
We will work through an example so you understand how capital gains tax might apply
Bob and Wendy own their main residence as well as a holiday house and a rental investment property.
The holiday home and the rental property are on adjacent blocks and were purchased in 2011.
Bob and Wendy lived in the holiday house for 2 years from 2011 until 2013. During this time, they rented out their primary residence.
Property prices increased a lot in 2021 and so they decided to look at selling assets. They sell their holiday house and the rental property.
The holiday house has never been rented out but used solely by Bob and Wendy. These costs relate to each property.
Sale Proceeds for each property $480,000
Purchase price for each property $300,000
Stamp Duty on Purchase price $ 40,000
Annual interest cost for each property $ 2,000
Annual council rates and land taxes $ 2,000
Repairs and maintenance $ 10,000
Construction of garage $ 25,000
Legal costs for opposing rezoning $ 15,000
Capital gains tax calculator
so, what is the capital gain when they sell the rental property ?
Capital proceeds $ 460,000
Cost Base :
Purchase Price $ 300,000
Stamp Duty $ 40,000
Garage $ 25,000
Legal costs for defending title $ 15,000
TOTAL $ 380,000
Total capital gains $ 80,000
Application of 50% cgt discount $ 40,000
Net capital gains $ 40,000
This is a basic capital gains tax estimate and more complex variables usually come into the calculations.
As with anything tax related you should seek tax advice before selling. Although your financial advisor may be able to assist with your overall financial situation, they may not be able to provide you with tax advice on your taxable capital gain.
A question that is sometimes asked is Does it Matter if I made a Capital Gain on a Property Based in NSW. Do i need to calculate capital gains tax nsw ?
The capital gains tax regime is an Australian based federal tax so State legislation won’t impact on your capital gain.
So how do I pay tax on my capital gain. A capital gain is added to your other taxable income to arrive at total taxable income. You then pay tax on your total taxable income including the capital gain.