Tax Tip 350: Trap - Selling a property within 12 months of renting it out

It is well known that if you hold a property for more than 12 months there is a 50% CGT discount that can apply and this has the effect of basically halving the tax payable.

But there is a trap where the property was a former main residence and this is because when that property is first rented out the cost base is reset to market value as it is taken to have been acquired on the date it was first rented. This means that if someone moves out of their main residence and sells it within 12 months of moving out it could be taxed without the benefit of the 50% Discount.


Example

Bart buys a home for $500,000 and lives in it for several years. He then decides to rent it out. At the time the tenants move in it is worth $1mil. For CGT purposes Bart will be taken to have acquired it for $1mil.

11 months later he cashes in on the Sydney FOMO boom and sells it for $1.2mil.

Bart says good, I will only pay tax on $100k as I get the 50% discount because I have held the property for 8 years.

The ATO say no, you are taking to have acquired it when the tenants moved in to it. And you sold it 8 months later so no 50% discount mate.

Bart is taxed on $200,000 instead of $100,000 – which he could have avoided by waiting one more month to sell.


Note that this would not have applied if Bart had used the 6 year rule.

See.

ATO ID 2004/945 Income tax: capital gains tax: main residence exemption - 'first use to produce income' rule and CGT discount

http://law.ato.gov.au/atolaw/view.htm?locid=aid/aid2004945

 

Yes but if he sought tax advice he would know of an alternative.

In these examples it assists to carefully consider if the property could bypass s118-192. (ie was it even used to partially produce income ?) This includes cases where a property is PARTIALLY used to produce income. One strategy is to let ONE BEDROOM for ONE night on Airbnb even for a nominal sum. There is no need to seek a tax deduction or any tax benefit. The goal is to use PART of the property to produce income so s118-192 doesnt apply at all. At anytime prior to sale.

Eg Bart received $20 from letting to the Newspaper guy from a nearby suburb. He then must pro-rata his CGT based on 1 night out of 2922 days or 0.00034223% as taxable. (Bart would face tax on $34 out of $200K). However, he can add ownership costs in the eight years to his costbase.. The CGT amount may be $0 (but not a loss). Bart is happy with paying $10 tax (??? needs to be determined) rather than tax on $200K.

It would be wise to consider the relevant comparision of the alternatives and seek advice from a property focussed tax adviser.

Can Part IVA apply to such an arrangement ? Doubtful. Declaring $1 or $20 of Airbnb income is a requirement under law. s118-192 prohibits revlauation is such factual cases. Part IVA doesnt seem to apply as the Airbnb matter doesnt produce any tax benefit. I use Airbnb as an example to avoid it appearing a contrived sham arrangement if it was family. Airbnb etc make it atrms length and assists with substantiation evidence.

 

What would be the dominant purpose in renting out a bedroom for just one night?

 

Dominant purpose doesnt matter. You are jumping ahead. - a tax graduate rookie error. Its a lesson I give graduates early. Walk through Part IVA. The taxpayer dominant purpose is receipt of income and is easily evident using a platform provider like Airbnb. Are you suggesting that not using s118-192 is a element of a scheme ? It is statutory law. The Commissioner wont cancel a statutory tax obligation and is obliged to assess the taxpayers self assessed income. Part IVA does have a flaw. It assumes taxpayers dont inflate income to seek a tax benefit.

The power of the Commissioner in Part IVA fail is the operative issue that some ignore. The Commissioner has no power to exclude income or cancel income. (s177C(1)(a) ITAA36) only allows income to be added) Hence s118-192 cant operate. And the statutory benefit of s118-192 not being used is a simple compliance test. Receive income tick. It need not be commercial either. It assists to be factual but Part IVA still doesnt apply to allow any remedy.

The inverse non-powers of Part IVA are often ignored by tax practitioners until more senior legal tax counsel is consulted or a proficient tax adviser gives advice.

 

In what circumstance would the 6 year rule not apply here @Terry_w ?

 

Bart might have used the main residence exemption on another property - or his spouse.

 

I am not saying the strategy won't work, but suggest everyone get their own tax advice rather than relying on these comments.

 

I don't really see this as an alternative either. If someone moves out and rents their home and then decides to sell it they cannot go back in time and make it income producing in the past.

If someone was planning ahead they could arrange it, but that would be a strange situation. Imagine someone thinking its 24 May now, I might move and and rent the property and then sell it on 24 of May next year. But it will take me a week to move out so I will quickly Airbnb it.

 

Absolutely !! It is a matter often not even considered. Many tax advisers deal with [property tax issues infrequently and I see regular mistakes. You would be suprised how often a PC member contacts me to discuss the failure to use the absence rule choice or s118.192

 

Correct. It wont apply and cant apply to the past. But many people consider a sale and get prelim tax advice. Its a tax planning strategy. Cant re-write history. And it only applies to a use of PART of the property to produce income. You dont want to trigger s118.192 by airbnb'ing the whole property. Self defeating. And sometimes we learn a sole trader had a home based business for a short time. That also counts. Unfortunately we need to dig it out as many taxpayers think its a cgt cost to have a home based business for a bedroom and dont see the benefit.

Tip : Tax advice and planning cant fix the past. Get early advice. One great example is third element costs. Very few taxpayers are aware of this and are entitled or may later become entitled. Even the home people live in now could later be eligible for past third element CGT costs. It is one of the most disregarded tax benefits. And often tax advisers arent even giving guidance. Or the owner doesnt seek tax adviser support. They just dont know. Its like suddenly learning in 8 years that there is a thing called a tax deduction and you never used it. And cant find the evidence.

We offer a CGT record keeping tool and recommend ALL properties have this record and it is maintained at least annually. I only know of one other practice who provide a similiar resource.

 

Thanks for highlighting this @Terry_w , I’m
sure we covered this topic in a forum discussion a while back.
I think it was likely re the market value reset s118 but a hidden trap as I heard it on property couch discussion.
Good idea as a seperate tax tip (as always)!

 

Very interesting thread.....

Do I understand right that the property has to partially produce income prior to being let as a whole for this strategy to work?

 

Also, I'm not sure I understand why in your example the CGT is only calculated for the single day when it was used as airbnb and is not also calculated on the 11 months when it was rented out.

 

Yes. The partial use of the main residence to produce income (s118.190) invalidates the ability to use s118.192 to reset the costbase. And then leaves open the ability to add non-deductible onwership costs to the costbase to further increase it PRIOR to any pro-rata using the formula is s118.185 and s118.190 which may BOTH be used.

Other examples are a sole trader or partner in partnership wjho uses some of their home to produce income at any time while they reside there. Many other situations eg choice to have used another property as exempt for a period of time etc Spouse with a different former main residence etc People fear the tax consequence of these matters but it can create planning and tax saving opportunities

 

Thanks, that makes sense. But I don’t understand why the same formulas would not be applicable also to the 11 months Bart rented out the property before selling, in Terry’s example?

 

Bart's property, in the example, was first used to produce income when it was rented out.

 

Let me clarify my question: if Bart had rented out one room for one night prior to moving out, and then rented out the whole house for 11 months, s118.192 would not apply, and he would have to pay CGT as calculated by Paul above in accordance with s118.185/s118.190. But why the same formula does not also apply to the 11 months when the property was rented out in full, which is a much greater amount, potentially negating the benefit of the strategy of renting the room out?

 

Yes. s118.192 is IMPOSED on Bart. Thereafter when he sells there are no exempt days hence s118.190 cant be used.

Thats a simple explanation of course. In practice, prudent tax advice would be asking Bart where he moved aftre he rented the former home. He may have a choice to use the absence rule in two ways.
1. Absence that is true with Bart not having a CGT impact on other property as he moves in with a friend, rental property or back home rather than a property he or a spouse owns. He would want to use the absence rule. or
2.Absence with a impact on another property he (or spouse) own but with knowledge of how this can change how the CGT will later calculate on that property.

 

IF s118.185 or sub190 are used WHILE Bart lives there s118.192 isnt even considered. There is no choice to elect to use OR not use s118.192 to reset the costbase.
Each situation is different. This is why we call it "advice"rather than "facts". We need to consider all the issues and then guide the best scenario for each client situation. 50% of clients will tell you something you didnt earlier know when you quiz them. I just discussed a client in barts situation who must use s118.192 who didnt want to. Bad luck. However I did discuss the 2 options in my prior post. for a $0 CGT choice. We will run the numbers using some numbers and assumptions so they make a informed decision.

There is actually a third option too....If Bart pushes the CGT issue onto another property and NEVER sells it he never triggers any tax issue. In later years he can move back in and die a week later and the tax issue evaporates as if it had never-ever been rented out

 

Ok. Sorry if I sound pedantic, but the way I interpreted your first post is that the 10-ish dollars was all the CGT that the guy that rented out one room for one night had to pay, even if he sold the house 11 months after renting out the whole house. Is this the case, or have I misinterpreted, and he also has to pay CGT proportional to the 11 months period? I appreciate that your reply it’s not a substitute for advice which is tailored to the specific conditions.