Are there ways to avoid or reduce paying capital gains tax (CGT) on an investment property entirely?
Yes, there are!
It's an unfortunate part of every property investor's journey that they will most likely eventually be liable for Capital Gains Tax or CGT.
However, there are a few strategies that can help you minimise your CGT when it comes to realising the profits on your investment property.
And some situations where you may be able to avoid it altogether.
Before we begin, let's outline what CGT is – when discussing real estate, it's a tax paid on the profit you make from the sale of an investment property.
A capital gain is the difference between what you paid for a property and what you sold it for if you purchased it with the intention to keep it as an investment.
In Australia, investors pay CGT on many asset sales such as:
- Real estate
- Shares
- Managed funds
- Collectables
How much CGT will you have to pay?
If you decide to sell an investment property, your CGT calculation will be based on the net sale price of the property minus your cost base (including any improvements) and minus certain expenses.
There is no specific Capital Gain Tax rate - this gain will then be added to the other income earned by the title holders in the relevant tax year to calculate the applicable tax.
Your capital gain is the proceeds earned from the sale minus:
- The total sum of the original purchase price
- Additional costs to improve
- Plus any incidentals, ownership, and title costs
- Then minus any government grants and building depreciation claimed
You may now be wondering what expenses you could include.
Well, the list is long but generally includes, but is not limited to, the following:
- Incidental costs – stamp duty, legal fees, some bank fees, buyer’s agent fees, advertising and marketing fees, and some travel expenses.
- Ownership costs – property searches, inspection costs.
- Improvement costs – replacing kitchens, bathrooms, flooring, or any other improvements you’ve made on the property such as additional toilet, decking, and additional floor space.
- Title costs – legal fees associated with organising and defending your title on the property.
When selling, the costs associated with the sale such as agent’s fees, styling, repainting, bank fees, etc. are used to reduce your gross selling price.
If the property was purchased with the intention to keep it as an investment property, as opposed to trading and selling, the capital gain can be reduced by 50% if it was held for more than 12 months.
However, you would have to add back the benefit of any depreciation you had claimed along the way relating to the capital works i.e. building depreciation.
Some investors actually make a capital loss when they sell their property, which would negate the need to pay any CGT at all.
It's important to understand that any loss is attributable to the titleholder.
To explain, a capital loss is when you sell a property for less than your reduced cost base as calculated using the parameters above.
While you really don’t want to be in the situation of making a loss, the good news is that you can carry a capital loss forward into future years and offset this against future capital gains you may make.
Note: CGT does not generally apply to inherited properties, but if the property doesn’t become your main residence then it may apply when that inherited property is sold.
Now you know what CGT is and how much it might cost you, here are a few ways to avoid CGT when selling an investment property.
Note: If your property was acquired before 20 September 1985, it will generally be exempt from capital gains tax which means you won’t have to pay tax on any profits, and you won’t be able to use any losses to reduce your assessable income.
1. Living on the property
When it comes to property, one of the major exemptions from CGT is if it's your home or principal place of residence (PPOR).
You can generally claim the main residence exemption from CGT for your home.
To get the exemption, the property must have a dwelling on it and you must have lived in it as your home - you're not entitled to the exemption for a vacant block.
Generally, a dwelling is considered to be your main residence if:
- You and your family live in it
- Your personal belongings are in it
- It is the address your mail is delivered to
- It is your address on the electoral roll
- Services such as phones, gas, and power are connected.
There is also a tax break that you may be able to access if your PPOR becomes a rental property (more about that later).
2. Using the ‘temporary absence’ rule
If you use a property you no longer live in to generate income, such as by renting it out, the ATO will allow you to continue treating it as your main residence for up to six years.
The exemption is only available where no other property is nominated as your main residence.
What's interesting about this rule is that if the same dwelling is reoccupied as your main residence, then the 6-year exemption resets.
So another 6 years of exemption is available from the date it next becomes income-producing.
Consider this…
If you’ve moved out of your home and rented it out, under the law, the property can still be treated as your principal residence for tax purposes for a period of up to six years.
Therefore, if you sell your property within that six years you may be exempt from paying CGT if you profit from the sale unless you chose a different home for this exemption.
You may also be exempt from paying capital gains on the income generated from the leasing of the property as this is normal income.
Sounds too good to be true?
Well, the answer to that is yes and no!
Unfortunately, in this scenario, you will still need to pay CGT on the sale of one of your properties if you have bought another "home".
The good news is, you can choose which property to have the exemption applied to.
For example, if you move out of your home and rent it out, but you also buy another property to live in, you will need to select one of the two properties as your principal place of residence and the other as the property that's liable for CGT.
3. Self-managed super fund
The ability to borrow money to invest in property, in particular, by using the mechanism of a self-managed super fund (SMSF) has resulted in the number of funds increasing rapidly in recent years.
According to the latest ATO statistics, there are 593,000 SMSFs holding $733 billion in total assets, with more than 1.1 million SMSF members, as of 30 June 2020.
And the good news for SMSF holders is that if you purchased an investment property through a self-managed super fund and have held it for at least 12 months, you can take advantage of some generous tax benefits.
For example, your capital gains tax will be discounted by a third if the sale takes place during the accumulation phase.
And if you sell the property during the pension phase, you won’t have to pay capital gains tax at all.
And if you sell the property while you’re still working and in the accumulation phase, you will only be taxed at a rate of 1 per cent.
Furthermore, if you’re holding on to the property for longer than a year, the tax rate will effectively drop to 10 per cent on the capital gain.
Buying a property within your SMSF comes with some risks, so you should never attempt it without first seeking specific professional advice and not relying on the general advice contained in this article.
4. Holding the property for at least 12 months
Any properties bought and sold within 12 months will be taxed at the full CGT rate.
But if you hold onto a property for longer than 12 months, you can reduce your capital gain using either the CGT discount method or the indexation method.
The CGT discount method applies a 50% discount to your capital gain.
So if a property sells for $200,000 above its cost base, only half of that amount ($100,000) will be added to your taxable income.
The indexation method is a bit more complicated and can only be used if you acquired property before 21 September 1999.
This method allows you to convert the original cost of property into today’s money by applying a CPI-based indexation factor.
5. Increasing your cost base
Another way to avoid or reduce CGT is by increasing your property’s cost base.
This is the cost of acquiring, holding, and disposing of a property, and is subtracted from the selling price to give you your capital gain.
According to the ATO, the cost base of a CGT asset is made up of:
- The money you paid for the asset
- The incidental costs of acquiring the asset, such as stamp duty and valuation fees
- The cost of owning the asset
- Capital costs to increase the asset’s value
- Capital costs of preserving or defending your title or rights to the asset.
Increasing the cost base can be done by including things like stamp duty, loan application fees, conveyancer’s fees, and the cost of any renovations.
6. Investing in affordable housing
When you sell a property that you used to provide affordable rental housing, you can reduce your CGT by up to 10% more than the 50% discount.
To qualify, your property must satisfy the following conditions:
- It must be fixed domestic residential premises, such as a house, unit, or apartment.
- Caravans, mobile homes, and houseboats do not qualify.
- Commercial residential premises do not qualify.
- It must be rented, or genuinely available for rent, at below-market rates to eligible tenants on low to moderate incomes and held for at least 3 years.
- It must be managed through a registered community housing provider.
Note: There is no one-fits-all approach!
Unfortunately, there is no silver bullet to avoiding CGT entirely on an investment property.
And, at the end of the day, if you have to pay CGT it means that you've made a profit on the property – which is what we all want, isn't it?
There are strategies to limit the tax payable on any capital gains, so it is worth getting specific advice. It is important to note that capital gains can be offset against income losses while capital losses can only be offset against capital gains.
