Here’s how:
It’s a little known and very misunderstood tax law known in the industry as the 6-year rule.
But if you know how it works before you start leasing your property, you can potentially avoid ever having to pay any capital gains taxes.
First;
What is (CGT) Capital Gains Tax?
Capital Gains Tax was introduced by the Australian Taxation Office as an income tax on the sale of an investment property that experienced capital growth.
To calculate capital growth (capital gains) the ATO deducts the original purchase price from the sale price. The difference between sale price and purchase price (less Stamp Duty) is the profit and is known as the capital gain. It is taxed at the same rate seller’s income taxation bracket level in the financial year the sale occurred.
If the sale price was less than the purchase price, this is known as a Capital Loss and generally will not be subject to taxation.
But you can avoid CGT on your investment property through several means.
- Owning the property for more than 12-months triggers a 50% reduction in your Capital Gains Tax payable
- Never selling the property means you never trigger a capital gains event – so you’ll never be taxed CGT
- Principal Place of Residence (PPOR) converted to a rental can avoid CGT. (More on this below)
Firstly…
What is a Principal Place of Residence?
Under current Australian taxation laws, the principal place of residence is not subject to capital gains tax upon sale.
A principal place of residence is essentially an owner occupied home. Be it a house, townhouse or even a unit. They all qualify. So long as the owner also lives in the property and is not using the property fro income producing purposes (charging rent).
However, after a few years, owner occupiers often move out of their principal property and into a new home, making their former home an investment property.
This is a very common practice in the Australian property market and can have significant tax advantages.
When you do so, in the eyes of the ATO, your property typically moves from being CGT exempt – to being an investment property. Therefore subject to CGT in the future.
How does the ATO prove it’s your principal place of residence?
The ATO uses some pretty standard and obvious criteria for this;
- It’s the main residence you keep your belongings
- It’s the main postal address you use
- it’s the address used on your drivers licence
- it’s the address used in the electoral role
- Your name is on all the utilities bills for that address
Now…how to avoid ever paying CGT on your former Principal place of residence.
Property And Capital Gains Tax 6 Year Rule
The property and capital gains tax 6 year rule is a taxation law which allows for property owners to reduce their tax liabilities when disposing of a main residence or investment property.
The rule applies to assets that have been held for a period of six years or more, and offers a variety of benefits, including a main residence exemption, cost base reduction, and a 50% CGT discount.
However, there are risks associated with the 6 year rule, and it is important to understand these before taking advantage of the rule.
This article will provide an overview of the 6 year rule and explain how it can be used to reduce tax liabilities.
What is the 6 Year Rule?
The 6 Year Rule provides an avenue for investors to defer capital gains tax for an extended period of time, allowing them to maximise their return on investment.
This rule allows homeowners to use their principal place of residence as an investment property for up to six years.
During this period, the homeowner cannot buy another principal place of residence without risking a CGT Event
The 6 Year Rule applies to each period of absence from the main residence.
If the homeowner does not reside in their main residence for more than one 6-year period, then the 6-year period will apply to each individual period of absence.
If the homeowner has been using the property to produce income for more than six years, then the capital gain will be subject to capital gains tax once the 6-year limit has been exceeded.
Additionally, the 50% CGT discount can be applied to further reduce the capital gain.
How Does the 6 Year Rule Work?
By applying the 6-year rule, homeowners have the opportunity to exempt themselves from paying capital gains tax on their principal property investment when they sell within that time period.
The main residence exemption and the 6-year rule can be used in conjunction with one another. Homeowners can choose to treat their former home as their main residence in the income year of the CGT event.
This allows them to own both their former home and their actual main residence during this time period. If the property is not used to produce income, they can treat it as their main residence for an unlimited period after they have moved out. If it is used to produce income, they can treat it as their main residence for up to six years after they have moved out.
A 50% CGT discount can also be applied to reduce the capital gain.
In summary, the 6-year rule allows homeowners to:
- 1. Use their investment property as their principal place of residence for up to six years while they rent it out.
- 2. Sell the property within the six-year period and be exempt from paying capital gains tax.
- 3. Treat their former home as their main residence in the income year of the CGT event.
What Assets Does the 6 Year Rule Apply To?
Investors can take advantage of the 6-year rule to defer capital gains tax on certain assets, provided they meet the specific criteria.
The 6-year rule applies to assets such as residential real estate assets.
Assets must meet certain conditions to be eligible for the 6-year rule, such as being used to generate income during the 6-year period and not being owned as part of a business.
To be eligible for the 6-year rule, the asset must also have been owned by the investor for at least six years, and they must have been living in the asset as their main residence for at least some of the time. Additionally, the investor must have owned the asset for the entire 6-year period and the asset must not have been used to generate income for more than 6 years.
If these conditions are met, the investor may be able to defer the capital gains tax for up to six years. During this time, the asset must be used to generate income and the investor must not use the asset as their main residence.
By using the 6-year rule, investors can defer their capital gains tax, allowing them to reinvest their funds and reduce their overall tax burden.
To get in touch with us to discuss your property in great detail, simply contact me here
What Are the Benefits of the 6 Year Rule?
Taking advantage of the 6-year rule can allow investors to defer the payment of capital gains tax on certain assets, providing an opportunity to reinvest funds and potentially reduce their overall tax liability.
The 6-year rule allows homeowners to use their principal place of residence as an investment property for up to six years without having to worry about paying Capital Gains Tax to the tax office in the future.
This provides the owner with the opportunity to claim the main residence exemption from CGT, as well as the ability to use the 50% CGT discount to reduce the taxable capital gain. During the six-year period, the owner can also add expenses to the cost base, which can further reduce the taxable capital gain.
In addition, the 6-year rule allows homeowners to sell the property within the six-year period and be exempt from CGT. This may provide the investor with an opportunity to realise a profit on the sale of the property without being subject to CGT.
Furthermore, the 6-year rule allows for multiple periods of absence from the property, so long as the total period does not exceed the 6-year limit. This provides the investor with flexibility in terms of when to sell the property and potentially maximize their return.
What Are the Risks of the 6 Year Rule?
The 6-year rule offers many potential tax saving benefits to investors, but it’s advised that you consult a good quality investment property specialist accountant before and during the lease period.
Firstly, if an investor has owned an investment property for less than 12 months, they may not be eligible to receive the 50% capital gains tax (CGT) discount. This means that, even if they have used the 6-year rule, they may be liable to pay CGT on the full amount of the capital gain.
Additionally, if an investor rents out their property for more than 6 years, they may be liable to pay CGT on the portion of the capital gain that has accrued beyond the 6-year limit.
Furthermore, if an investor moves in and out of their investment property multiple times, the 6-year rule may not apply in its entirety for each period of absence. In such cases, the investor may have to pay CGT on the portion of the capital gain that has accumulated beyond the 6-year limit.
Important Note: The 6-year rule does not apply to foreign residents, and they may be liable to pay CGT on the full amount of the capital gain.
Therefore, it is important for investors to speak with their accountant prior to leasing out their principal place of residence to ensure the best tax strategy is implemented.
Property Market Valuation for CGT Purposes
There’s one more hurdle you must jump in order to satisfy the ATO’s requirements around Capital Gains Tax on an investment property.
When you convert your principal place of residence to a rental property, the ATO needs to know how much it’s worth at the time the property becomes income producing.
To do that, you must have your property valued by an independent party of good standing and knowledgeable in the field.
This can be your local realtor, a registered property valuer or your quantity surveyor.
At WRCQS we guarnatee can handle your property valuation for CGT purposes as well as your tax depreciation schedule.
We can even do your insurance replacement valuation report to ensure your not underinsured and at risk of losing everything
You can also find a lot more helpful info about your potential tax savings by checking out our main page.
If you found this helpful, you may also find some of my other articles beneficial too. And to see some real life examples of what our clients have been receiving in tax depreciation deductions, check out our Client Portfolio page.
This article was written by William Callaghan A.A.I.Q.S.
2nd generation Quantity Surveyor and founder of WRC Quantity Surveying
