Tax Tip 86: Don’t be so fearful of generating income from the main residence

Don’t be so fearful of generating income from the main residence

Seek advice on this, but CGT on the main residence may not be so scary.


If you rented a property out straight away after purchasing it and then moved into it any CGT in the future will be worked out on a time basis.

The formula is

No. days rented/No. days owned = CG subject to tax.


For example

Say you bought a property for $500,000 and rented it out for 5 years without ever living in it. After 5 years it was worth $1mil. If you sold it at this point 100% of the gain would be taxed, less expenses.


But if you moved in after 5 years and then sold it at the year 10 mark it would only be 50% of the gain that is taxed. So if you sold it for $1,500,000 for example only $500,000 of this gain would be taxable. (5/10 = 50%. $1mil gain x 50% = $500k.).


If you lived in the property for 15 years then the percentage subject to tax would drop = 5/20 = 10%. So the longer you live there the less percentage of the property will be taxed.


But against this gain you can then claim all associated expenses that had not been claimed before. For example, interest on the loan, rates, strata, insurance etc. Even these expenses incurred while you were living there can be claimed. See Tax Tip 76: Calculating the Cost Base for CGT purposes.


These expenses are used to increase the cost base. Then the 50% discount is applied. And then any CG is divided between owners. So say 5 years of expenses was $100,000. There is stamp duty, conveyancing, selling agent fees etc which may be $50,000 all up. So your $1mil gain becomes $850,000. Only 50% of this is taxable so $424,000. The 50% CGT discount is applied so it drops to $212,000. If you were the sole owner and were on the top tax rate of 47% you would pay less than $100,000 in CGT.


That equates to 10% of the $1mil ‘gain’.


But, wait there is more, while you were renting it out you may have saved $10k per year in tax by negative gearing the property plus you were have had access to more cash to make further investments and you would have improved your serviceability (thanks @Redom). Consider also the time value of money – money now is worth more than the same amount later, so getting the savings upfront can help with compounding.


So don’t be so fearful of renting out the main residence before it becomes a main residence.


Combine this concept with the strategy of renting instead of owning a main residence as discussed here Strategy: Rent where you live and Buy Investment Properties


And also combine it with the use of the 6 year rule, on another property, as described here Tax Tip 23: The 6 year Absent from Main Residence Rule


And you could be on to a powerful combination of strategies.

 

OK, so real-world example -

Lets say my PPOR gains $1,000,000 in the time between purchase and sale.
I rent out a room which is available to rent 100% of the time. The room occupies 5.8% of the floor area.
So the taxable CG is $58,000
Less 50% discount = $29,000.
At my wife's marginal tax rate (she owns the house!) - tax bill of $5510.

Is that right?

Thanks

JB

 

The cost base would be reset to the market value at the first time it is used to product income. So you would miss out on claiming any expenses before that point. Your tax would be much more in this instance.

 

Terry - are my sums correct assuming a theoretical CG of $1million from the point when the property is first used to produce income?

Thanks

JB

 

No, a quick glance and I don't think they are correct.

 

Assuming the $1m profit is calculated after all CGT costs and is based on the change in market value based on s118-192 etc then its possible that is correct. This would assume 5.8% income use for the whole period. Based on Terry's original post it summarises that $5k v's $1m profit is not a serious concern.

 

But all the purchase costs couldn't be used to increase the cost base as s118-192 resets it at market value at the date it first produces income. So the CGT may be higher. But it won't amount to too much probably.

 

Assuming the total gain is $1m....Whether costs are or not included.
I generally find taxpayers fear huge tax bills with CGT and its often less than feared.

 

So when a PPOR becomes an IP the CGT clock starts from the Value of the property upon Exit/date available for rent?

So in my case, Prop A purchased at 340k. Moved straight in and was PPOR for 5 years. Valuation at the time of Exit to next PPOR (Prop B) was 460k. Current Val is 650k. So CGT is payable only on the 190k difference since converting Prop A into an IP?

Furthermore as that was 5 years since Exit to date, if we were to move back into Prop A this year before 6 years away is up, what happens to the CGT clock? Or that is lost due to our current PPOR, Prop B, being claimed? Prop B would then convert to IP and the question continues for this one, if that makes sense? Prop B, current PPOR, has gone from 320k to 460k.

All others after this are easy as they're built as IP's only and subject to CGT from availability for rent date. But how do you determine Valuation amount at this point?

 

Yes
You could use the 6 year rule to avoid CGT on property A

 

Isn't that effectively holding 2 PPoR. Hold 2 and keep moving into another before 6 years lapse. I thought the 6 years policy ends as soon as you claim another PPoR

 

Only one of them could be exempt for the one period. The good part is you could choose which one only when the first of the 2 is sold.

 

Is the calculation for % of floor space only the room? Do you need to also consider other general common areas like living room?

 

Yes you do.

 

That's my issue. When I include the other general areas, it becomes 50% of the floor space. Would renting out a "room" become viable from a CG tax perspective? I intend to live in my PPOR for the next 20 years.

 

Viable? You just have to do the numbers.

A small gain now could lead to a large tax bill later.

 

Based on your example, if I sell the property at the year 15 instead of 10, does that mean I will have the CGT exemption for the 5 year (between year 10 to 15, because of the 6 year rules)? And I am still liable for the CGT before I moved in (between year 1 to 5)?

 

No.
Yes as a %

 

Can I get some thoughts on this please?
Home bought Dec 2015. 1.6 mill.
Current val (for arguments sake): 2.4 mill.
Loan on property 300k.
The PPOR itself could easily house extra people but partner doesn't want to.

Planning to build a studio out the back for 45k.
Rent that out for $500 a week.
(Will have associated costs). Assume it can be deprecated.
The studio to occupy ~30 sqm of land. The full block of land is over 1000 sqm.

Not planning to sell anything for 30 odd years. Perhaps assume a 7.5% annual growth rate.

What tax implications would I have now and in the future?

 

Cgt when sell
Land tax exempt if NSW probably
Income tax on rent