Tax Issues and Considerations in the Sale of Rental Property
When it comes to tax compliance, rental property, or property used to derive income from rent, differs from residential or commercial property. We have previously covered the tax issues relating to income and expenses deductions for rental property owners, including capital gains tax considerations. However, it is important for rental property owners to be aware of the capital gains tax and other compliance issues that affect their ability to dispose of rental property.
The Australian Tax Office (ATO) has issued reports outlining various issues that they encounter in the reporting of rental income and disposal of rental property. It is our goal to inform clients and unfamiliar readers alike of these issues to ensure that they do not end up engaged in an unnecessary dispute with the ATO. Tax disputes or follow-up action by the ATO is incredibly time-consuming and stressful for all concerned, but by gaining a comprehensive insight into the cause of such disputes and follow-ups, they can be avoided by rental property owners seeking to dispose of their property.
In the ATO report into rental property income reporting and asset disposal, the most frequently cited problems are with the reporting, calculating, and record-keeping habits of those concerned, especially with regard to capital gains.
Allow us to introduce you to the most important capital gains tax considerations for those looking to dispose of rental premises, and how best to calculate and record capital gains. We will also examine record-keeping techniques designed to protect you from unnecessary audits or follow-up action by making sure that you have all the required information on hand in a form that is easily accessible and can be produced upon request.
Key issues examined in this report include:
• The calculation, recording, and reporting of capital gains or losses
• Proceeds of sale recording
• Cost base determination, used to calculate capital gain or loss
• Main residence concession and its effect on rental premises
• Key areas that the ATO focuses on in this context to ensure compliance.
Selling A Rental Property
A rental premises is one that is used to derive income from rent or rent-related payments. If you purchase a property in order to use it to earn income from rent, any subsequent sale of the property is a capital gains tax event and will require the appropriate records to be kept and reports to be made.
The sale of rental property attracts capital gains tax obligations where the seller intends to derive profit from the sale of said property, or the property is to be developed or subdivided as part of a profit-making venture. Property is an important asset, so it is highly likely that the sale of a rental property is initiated by a desire to derive profit from the sale.
Proceeds from the sale of rental property are reported as income, whether that income is earned as part of a property business (developing or subdividing the property) or as a one-off profit earning venture. For many property sellers, the latter is the most common, but for tax purposes this is still assessed as carrying on an enterprise. This is due to the fact that profit is likely to be derived from the sale, as well as the fact that the property was used to derive income prior to the sale.
It is very important to keep records of all relevant works and transactions which may be used to calculate your tax burden, and especially capital gains tax following the sale of the property. Such records include the stake of each owner, where a rental property is owned by more than one person, as well as details and records of any works or improvements made to the property whilst it was being used to derive rental income. Records of rental income should also be kept. When you decide to sell your rental property, it is very important that records are kept for any offer made and your resulting acceptance documentation. A list of depreciating assets should also be kept for tax assessment purposes.
Capital Gains Tax
When selling an asset such as a rental property, any gain made from the sale proceeds is referred to for tax purposes as a capital gain. If a loss is made, that is that the sale proceeds do not meet the amount paid for the property, then a capital loss is likely to have been incurred following the sale. Capital gains tax is part of the income tax assessment conducted by the ATO, and is not a separate tax in its own right. Capital gains and losses are used to calculate your total assessable income for the year in which the CGT event occurred.
If a rental property is owned by more than one individual, any capital gain resulting from the sale of the property is split evenly between the owners, as determined by each owner’s legal interest or stake in the rental property and the proceeds derived from its sale. A good example is this; if two partners in a relationship or marriage jointly own a rental property, and decide to sell it, then any capital gain from the sale is split evenly between them, meaning that 50% of the capital gain is applied to the assessment of each partner’s individual income tax return for the year in which the sale occurred.
This also applies to capital losses. If a capital loss is incurred following the sale of a rental property, the value of this loss is applied evenly to the personal income tax assessment conducted for each individual owner based on their legal interest or stake in the property. Capital losses may be used to offset capital gains made in the present income year, or deferred in order to offset gains made in future income years.
If the property was acquired by the seller prior to September 20th 1985, any capital gain or loss on the sale of that property can generally be disregarded, as this was the date in which capital gains tax was introduced and began to be enforced. If the property was acquired before this date, but you have carried out major works or development on the property since then, these may constitute capital works, and contribute to a capital gain or loss on the sale of that property.
The ATO has warned rental property owners about capital gains tax concessions for small businesses, which are eligible to make use of four concessions when disposing of property assets. Rental properties are not considered to be active enterprise assets, that is, your rental property activity does not constitute a going concern unless it is part of a registered rental property business. This means that small business capital gains tax concessions cannot be applied to the sale of rental property by private owners, even if you are running a small business enterprise.
A good example is negative gearing, if a rental property has been negatively geared, it is assessed as a passive investment and not part of any enterprise or going concern, therefore it is ineligible for any relevant concessions or discounts.
CGT and Your Assessable Income
Capital gains tax is used to assess your income which you pay tax on when you submit an annual income tax return. It is regarded as a component of income tax rather than being a separate tax in its own right. Whatever your marginal tax rate is, this is used to calculate the tax burden on any capital gains you make during an income year, unless these are offset by capital losses.
You attract a capital gains tax burden whenever your derive proceeds from the sale of an asset which exceed the value of the asset’s cost base.
When a capital asset is sold, the amount you receive is referred to as the capital proceeds of that sale. Capital proceeds are the amount of money or the monetary value of goods, services, or property that you receive or are entitled to receive from the sale of your asset.
When filling our your income tax return, the capital gain or loss amount you must include is calculated as:
• The total capital gain amount for that income year, that is, the combined total of your capital gains minus capital losses incurred through the sale of capital assets
• Any relevant CGT discounts may be applied to arrive at a final taxable capital gains figure.
Determining your Rental Premises Proceeds of Sale Figure
If you decide to sell a rental property, the tax burden is applied at the date the contract is signed and not the date of settlement. That is, if you sign the contract in April but settlement does not occur until July, you are taxed for the financial year in which the contract was signed (the financial year including April and ending in June, prior to the settlement date).
A typical contract of sale for a rental property, or other residential property, includes the following:
• The land on which the premises is located
• Depreciating assets.
It is standard practice for the land and any buildings attached to it to be assessed as a single asset and referred to as such, e.g. the rental property. Depreciating assets, elements of the property whose tax value is determined by depreciation rules, are assessed based on their value at the time or purchase or the value ascribed to them by a suitable and independent valuation practitioner.
The rental property itself, including the land and buildings, is a capital gains tax event in its own right regardless of the depreciating assets, which are treated separately. The contract of sale usually lists the amount offered (and accepted by the seller) for each asset, this includes the rental property (buildings and land) and depreciating assets.
In order to calculate the CGT attracting proceeds of sale, you need to identify the value of the depreciating assets as listed in the sale contract, and deduct this amount from the total value of the contract. For CGT purposes, depreciating assets to do not constitute part of the cost base for a rental property, and therefore are excluded. The final cost-base and capital proceeds is recorded as the amount received or which you are entitled to receive, for the rental property minus the amount attributed to depreciating assets.
If you decide not to include the depreciating assets in the contract of sale, i.e. you are giving them away to the buyer, then you are assessable as having obtained the market value of these depreciating assets at the time the CGT event occurred. This is referred to as market value substitution of capital proceeds.
An Example of Capital Proceeds Calculation
If the sale contract for a rental property is valued at $700,000, and the depreciating assets identified in the contract are valued at $5000, then the capital proceeds are calculated by deducting the $5000 offered for the depreciating assets from the $700,000 offered for the rental property itself. This results in a capital proceeds amount of $695,000.
Determining Your Rental Property Cost Base
This is the next step, as your total CGT liability is calculated as the proceeds of sale/capital proceeds (described above) minus the rental property’s cost base. An asset’s cost base is much more than just the amount which you paid for an asset, although that is an important determiner.
For CGT purposes, an asset’s cost base has five elements which are used when making the calculation. These first two are designed to cover the standard capital costs of acquiring and disposing of rental property:
• Up to ten listed incidental costs, costs associated with the acquisition or sale of the rental property, such as: solicitor, surveyor, or real-estate agent fees. Stamp duty costs, the cost of marketing the property for disposal, and the cost of borrowing money in order to acquire the rental property.
• Acquisition cost, the amount which you paid to obtain legal ownership of the rental property or asset. May be calculated as the asset’s market value in some cases, such as in the event that you acquired the property as a gift from some benefactor.
The remaining three cost base elements are related to the costs of owning, improving, or defending your title as the asset’s owner:
• If acquired after August 20 1991, the cost of ownership only includes costs which you are ineligible to claim as tax deductible expenses. If you are deriving rental income from the property, ownership expenses are likely assessable as income deductions. If you use or have used the rental property for private purposes, ownership expenses incurred during the period/s of private use may be used in the calculation of the property’s CGT cost base. Your cost of owning the rental property includes maintenance expenses, insurance and repair expenses, land tax, council rates, and interest on loans acquired for the purchase and/or improvement of the rental property.
• Capital costs incurred during an attempt to preserve or increase the value of the rental property. Such capital costs include the expenses associated with performing substantial renovations or improvements on the rental property which affect its market value.
• Capital costs associated with the establishment, preservation, or defense of legal title. Such costs are less common than the other contributors to a rental property’s cost base, as these are usually incurred through litigation or other disputes such as rezoning or compulsory acquisition of land.
Acquisition costs, capital improvement costs, and incidental costs (costs of ownership) are the most common and important elements to consider when calculating your rental property’s cost base.
An Example of Cost Base Calculation
If the sale contract for your rental property was valued at $500,000, you must first deduct the value of depreciating assets from this amount in order to give the acquisition cost. If the cost of depreciating assets was not listed on the sale contract, you may use an independent valuation practitioner to determine their value.
If those depreciating assets are valued at $4000, this amount is deducted from the sale price of $500,000, resulting in an acquisition cost of $696,000.
Incidental costs incurred during the acquisition of your rental property included solicitor and agent fees of $3000, stamp duty of $7000, and borrowing costs averaged to $1000.
If you used to the property to derive income from rent or rent-related payments for 10 years, and during that time you claimed deductions to the total of $5000 over 10 years, than the remaining $6000 in incidental costs should be added to the cost base for your rental property.
Any ownership costs which you are not eligible to claim as a deduction, such as the $1000 you spend on repairing the rental property’s roof during a time when you used it for private purposes, are also added to the cost base.
If you decided to protect the value of your rental property asset, or improve its value by building a large shed at the rear of the property at the cost of $50,000, you add this capital cost to the rental property’s cost base. Though this will need to be adjusted if you claimed capital works expenses as deductions to your income tax applied to income derived from rent.
The combined total of these cost base elements gives the rental property’s cost base, which is then used to calculate capital gains tax on the disposal of the property.
Calculating your Capital Gain
There are three prescribed methods for calculating your capital gain from the disposal of an asset such as a rental property. These are the:
• Other method
• Discount method, and
• Indexation method.
Generally you may use the calculation method that will provide you with the best tax burden result, though these methods are subject to regulatory change.
The other method is used to calculate the capital gain obtained through the sale of an asset which you have held for less than 12 months. To use this method, you simply deduct the cost base which we described above from the capital proceeds of the sale. The resulting difference is your capital gain or loss which may be applied to your income tax return.
Discount methods available for the calculation of capital gains on the sale of rental property are available to individuals, who are currently eligible for a 50% discount on capital gains. Discount methods are only applicable if you have held the asset for a minimum period of 12 months. If you have owned your rental property for more than 12 months, and you own it as an individual, then you may calculate your capital gain as you would using the other method and then deduct the 50% discount to give your total capital gain.
Indexation methods are only available for assets acquired before September 21 1999. This method uses an indexation factor (CPI) to increase the cost base, however, the indexation factor was frozen in the 1999 September quarter, so if you are eligible to use this method you can index the cost in line with the 1999 September indexation factor.
Main Residence Concession
The family home or an individual’s primary residence is not subject to capital gains tax, so if you are selling the home that you live in, it is not going to attract a CGT burden. This exemption can sometimes be applied to a rental property when that rental property is also your home or main residence.
To be eligible for the main residence concession, the rental property must:
• Have been your primary residence, i.e. your home, for the entire period that you owned the property.
• Land attached to the property must not exceed two hectares.
• Not have been used in the production of assessable income which is subject to another exception.
It is important to be aware of the main residence concession. Say for example that divided your home into two halves, and rented out one half of your property to a tenant and derived rental income from it. In the event that you sell the property, the half which you occupied may be subject to the main residence exemption, and the other half subject to CGT.
In short, if you use your home to derive income from rent or rent-related payments, you may apportion the proceeds of sale using the main residence exemption to reduce the CGT burden on the sale. If the rental property was only used to derive income from rent for a given period, but served as your main residence at the time of sale, then you may be eligible for a partial CGT exemption.
You are also able to nominate a dwelling as your primary residence even if you do not reside there, but you must have resided there at some point.
The Six Year Rule
You are able to use your main residence to derive rental income for up to six years, without you residing there, and still have it classified as your home/main residence and therefore qualify for the main residence exemption.
For example, if you decide to go travelling, or to move temporarily for work or leisure, and rent out your home while you are away, so long as you return to it within six years the property will be exempt from CGT even though it was used as a rental property.
The ATO regularly lists poor record keeping as one of its primary concerns, and failing to maintain the required records can result in the ATO taking action against you. By keeping detailed and accurate records of your expenses, you will be able to correctly and effectively calculate the capital gains tax liability you will face when you sell your property. This ensures that you do not pay more tax than you have to, and that you do not face unnecessary action by the ATO.
Records are vital for calculating your cost base, and if the relevant records are not kept than the relevant items are excluded from your cost base, thus increasing your capital gains tax liability. By keeping records of all the transactions involved in the acquisition, ownership, maintenance, improvement, and disposal of your property, you will be able to deduct a sizeable cost base from your final CGT liability.
The ATO also requires that you keep records for a period of five years after the CGT event which those records relate to. Penalties apply for the failure to keep these records, as the ATO may conduct follow-up checks. If you have the records, then these checks will be over and done with in no time at all. If you do not have the records, you could face the penalties for improper record keeping and the possibility of further action or investigation by the ATO.
Important points in rental property record keeping:
• Keep copies of the purchase contract for your property, and keep receipts for all transactions and expenses that relate to the acquisition of your property, including legal fees, stamp duty, valuation fees etc.
• If a CGT event occurs, such as selling your property or performing capital works, keep records of all related transactions and expenses such as the sale contract and conveyancing costs. For capital works, keep receipts for work and the details of providers.
• Keep records of all expenditure on improving, maintaining, and repairing your property. Also include records of expenditure related to establishing or defending your legal ownership of the property.
It is vital that you keep records of all expenses and transactions that may be relevant to both income tax in the case of rental income, and capital gains tax in the case of acquiring, improving, and disposing of property. Tax rules are subject to change and the ATO may require more detailed information from you in the future, so it is best to have this on hand to reduce your potential liability.
The cost of reconstructing records which you did not keep can be significant, especially if this is done in compliance with ATO or other regulatory action. Good record keeping can also reduce the tax burden passed on to beneficiaries if you happen to leave them property or assets in your will.
If you own a property in conjunction with another individual or group, then keep records relating to your share of the ownership and expenses, as well as more comprehensive records which may be used in the event of a dispute or disagreement with the other owners.
Property used for residential purposes generally does not attract GST burden, instead they are input taxed. Input tax means that GST is not charged against residential property, so therefore rental property owners are unable to charge GST to their tenants or to claim GST credits. GST should not be included in the sale amount of residential property, either.
Input Tax on residential premises means that:
• GST is not to be included in the sale of residential property
• GST credits cannot be claimed on the sale amount or rental income derived from residential premises
• GST cannot bet charged to tenants paying rent for residential premises.
Note that commercial rental properties ARE subject to GST rules as they apply to all business and enterprise in Australia. The above concerns residential premises, rental properties that are let to tenants who reside at the property or use it for private/non-income-producing purposes.
GST rules differ for residential property that is assessable as new, that is, developed and then sold without being sold by the party that ordered it to be built. Residential property is assessed as new when any of the following points apply in the circumstances:
• The premises have not been subject to sale as residential property
• The premises have been developed through substantial renovation or redevelopment
• Old buildings have been demolished and replaced with new buildings
The sale of a new residential property is subject to normal GST rules and GST credit requirements. If you are selling a new residential property, you are able to claim GST credits for purchases related to the sale, such as conveyancing fees and agent fees. You are also liable to pay GST on the sale of a new residential premises.
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