How to avoid capital gains tax on investment property
Transforming a property into a successful investment brings a deep sense of satisfaction. You’ve identified potential, nurtured its value, and now stand to reap the rewards.
A portion of your hard-earned profit, built through years of strategic planning, vanishes into capital gains tax.
This can be a disheartening reality for any investor. So now the question arises: Can we get rid of the taxman partly or fully?
For that, we first need to get the basics right.
Understanding capital gains tax
Owning investment properties can be a fantastic way to build wealth. But when it comes time to sell and collect your profits, there’s one hurdle to jump: capital gains tax (CGT).
CGT is the tax on the profit you make from selling your investment property i.e., the government taking a slice of your profits. While it might feel discouraging, here’s the good news: there are legal ways to minimize this tax and keep more of your hard-earned money.
key strategies to avoid capital gains tax
Primary residence exemption
“Designating a property as your primary residence can exempt you from CGT”
CGT does not apply to the sale of a property designated as your primary residence, or Principal Place of Residence (PPOR). This exemption is based on the notion that the home is used for personal living and not as an income-generating investment.
When a property is sold that has been used as the homeowner’s main residence, any capital gain from the sale is typically exempt from CGT.
But there are certain conditions to qualify for the primary residence exemption:
- The property must have been the main residence for the entire period the owner had possession.
- The property should not have been used to generate assessable income – meaning no part of the property was rented out or used for business.
- The land on which the house is situated must be 2 hectares or less.
Temporary absence rule
“Maintain a property’s status as a primary residence for up to six years, even if it is rented out”
The Temporary Absence Rule allows property owners to rent out their primary residence for up to six years while maintaining its status as their main residence for CGT purposes.
This basically means you can generate rental income from the property without losing the CGT exemption, provided the property is not used to produce income for more than six consecutive years.
Again, there are some conditions we should know:
- You must have lived in the home as your main residence immediately before renting it out.
- You cannot treat another property as your main residence during this period (except for a limited overlap of up to six months if acquiring a new home).
The 6-year rule
“6-year rule can benefit property owners who rent out their former primary residences”
The CGT 6-Year Rule is an extension of the Temporary Absence Rule.
Imagine you had to move out of your home for a while, but you still have a plan to return someday. The good news is, if you rent it out for a short time, you might be able to avoid capital gains tax when you eventually sell it. .
Here’s how it works:
- This house was once your primary residence.
- For some reason, you need to move out for a while.
- Instead of leaving it empty, you decide to rent it out to generate some income.
- The 6-Year Window: Here’s the key part! As long as you sell the property within six years of moving out, you can still claim it as your main residence for the entire period, even while it was rented.
Why is this helpful? Because claiming it as your main residence can potentially exempt you from capital gains tax on the sale. So, even though you weren’t physically living there for a bit, the taxman might still consider it your “home base” for tax purposes.
Example: John lived in his Sydney home for five years, then moved abroad and rented out the house. He sold the property five years later. Under the 6-Year Rule, John can claim the property as his primary residence for CGT purposes, exempting the entire gain from CGT.
Investing through self-managed superannuation fund (SMSFs)
SMSFs is a type of retirement savings account in Australia that gives members more control over their investments compared to traditional superannuation options.
Unlike larger funds, you and a small group (up to six individuals) act as trustees, managing the fund yourselves as this offer greater flexibility in investment choices.
Benefits of buying investment property through SMSFs can offer significant tax advantages:
- During the Accumulation Phase: Rental income earned by the SMSF is taxed at a concessional rate of 15%, significantly lower than personal income tax rates, which can be as high as 45%. If the property is sold after being held for at least 12 months, a one-third discount on CGT applies, effectively reducing the CGT rate to 10%.
- During the Pension Phase: When the SMSF is in the pension phase, the income from the property is tax-free, and no CGT is payable on the sale of the property. This tax exemption helps the SMSF maintain a healthy level of assets, ensuring a strong foundation for your ongoing pension payments.
These strategies provide avenues for property investors to minimize their CGT liabilities legally. Proper understanding and application of these rules can lead to substantial savings and more efficient tax planning in property investment scenarios.
Reducing capital gains tax if not avoidable
Several strategies can be employed to legally reduce this tax burden:
50% CGT discount for properties held over 12 months
If you hold a property for more than one year before selling it, you qualify for a 50% discount on the CGT. This means if your capital gain on the sale is $100,000, only $50,000 is considered taxable income. This discount significantly reduces the tax you owe, making long-term investments more appealing.
Increasing the cost base
Increasing the cost base of your property reduces the capital gain, which is the difference between the selling price and the cost base.
Although this may sound illegal, it’s not. Here’s how to legally increase your cost base:
- Purchase Costs: These include the purchase price, stamp duty, legal fees, and Investment property buyers agent fees involved in the acquisition.
- Improvement Costs: Money spent on renovations or improvements that add value to the property can be added to the cost base. For instance, costs incurred in constructing an extension, landscaping, or modernizing a kitchen.
- Ownership Costs: Ongoing costs such as council rates, property taxes, and insurance may be included if the property was not income-producing.
Lets understand with a simple example:
Imagine you purchased an investment property in 2015 for $400,000, including stamp duty and legal fees. Over the years, you spent $50,000 on improvements and $30,000 on property taxes and insurance. In 2023, you sell the property for $650,000. Your cost base would be $480,000 ($400,000 + $50,000 + $30,000), resulting in a capital gain of $170,000. With the 50% CGT discount, you only declare $85,000 as taxable capital gain.
These methods are not only legal but encouraged by tax systems to promote investment and property upkeep.
At the Investor’s Agency, we ensure you are applying these strategies correctly and to your best advantage.
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Advanced strategies
Impact of different ownership structures on cgt liabilities
Ownership structures can significantly influence Capital Gains Tax (CGT) liabilities.
Individual Ownership
This is the most straightforward ownership form where an asset is owned directly by an individual. CGT is calculated on the capital gains at the individual’s personal income tax rate.
If you buy an investment property for $300,000 and sells it later for $450,000, realizing a capital gain of $150,000 and your marginal tax rate is let’s say 37%, your CGT liability would be significant—potentially $55,500, assuming no other deductions or discounts apply.
While individual ownership is simple and does not require complex legal structures, it may lead to higher CGT if the individual’s income places them in a high tax bracket.
Partnerships
In a partnership, two or more individuals or entities own an asset together. CGT is not paid by the partnership itself. Instead, each partner includes their share of the capital gain or loss in their personal tax returns and pays CGT according to their personal tax rates.
Example: If Bob and Carol own a property as partners and sell it, each reports half of the capital gain on their tax returns. If they gain $100,000 on the sale, each declares $50,000. If Bob is in a 19% tax bracket and Carol in a 32.5% bracket, Bob would pay $9,500, and Carol would pay $16,250 in CGT.
This structure can be advantageous if one or more partners are in lower tax brackets, potentially reducing the overall CGT liability compared to individual ownership.
Trusts
A trust is a legal entity where a trustee holds assets for the benefit of the trust’s beneficiaries. Trusts can distribute capital gains among beneficiaries, which can be advantageous for CGT planning.
Suppose a trust owns a property that is sold for a capital gain of $200,000. The trustee can distribute this gain among several beneficiaries, who might each be in lower tax brackets. If the gain is split among four beneficiaries, each receiving $50,000, their lower marginal tax rates can significantly reduce the total CGT paid compared to if one person were taxed on the entire gain.
Conclusion
While capital gains tax might seem like a roadblock on your property investment journey, it doesn’t have to be a dead end. By understanding the rules and implementing smart strategies, you can significantly reduce your tax burden and keep more of your hard-earned profits.
You can turn that potential tax headache into a celebratory high five with your future self! When in doubt, remember, we at the Investor’s Agency can ensure you’re on the right track to maximizing your return on investment.
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