How to leverage the capital gains tax 6-year rule

Capital gains tax (CGT) can significantly impact your profits when you're selling your property in Australia. However, the capital gains tax 6-year rule offers an opportunity to reduce or even eliminate CGT if you've used your home as your principal place of residence (PPOR) and later rented it out.

In this guide, we'll explain how this rule works and how you can use it to maximise tax savings when selling your property.

What is CGT and the 6-year rule?

Capital gains tax is the tax on the profit made when you sell a property or other assets. For property investors, CGT is calculated based on the difference between the sale price and the cost base, which includes the purchase price and associated costs like legal fees and improvements. This gain forms part of your assessable income and is reported in your tax return.

The 6-year rule allows you to continue treating a former home as your main residence for up to six years after moving out, even if you're earning rental income. By selling within this period, you can claim the main residence exemption, which can substantially reduce your CGT liability.

What is the principal place of residence?

Your PPOR is the home where you primarily live. For tax purposes, it's essential because only your PPOR qualifies for the main residence exemption, which helps you avoid capital gains tax.

The Australian Taxation Office (ATO) defines your PPOR based on:

• Living there full-time.
• Storing personal belongings.
• Receiving mail at the property.
• Having utilities in your name.
• Listing the address on the electoral roll.

For example, Samantha lived in her Melbourne apartment for three years before moving to a new property. Her apartment still qualifies as her PPOR for CGT purposes, allowing her to claim the CGT main residence exemption when selling.

Essentially, using the 6-year rule strategically and correctly designating your property as a PPOR can help you minimise your tax liability and maximise profits when you're selling.

Who is eligible and what are the limitations of the 6-year rule?

To maximise the benefits of the 6-year rule and reduce your CGT liability, it's essential to meet the following criteria:

• The property must have been your PPOR before you moved out.
• You cannot nominate another property as your main residence during the six-year period.
• The property can be rented out during this period but must maintain its PPOR status to claim the main residence exemption.

And, you must be aware of the following limitations:

1. 6-year cap: If you rent out the property for more than six years, CGT will apply on any additional time rented.
2. PPOR requirement: The property must have been your PPOR before renting; if not, the 6-year rule doesn't apply.
3. Single property rule: You cannot claim another property as your main residence while applying the 6-year exemption.
4. Partial income use: If part of the property is used for income-producing purposes, such as a business, that portion may still attract CGT.
5. Foreign residency: If you become a foreign resident, you may lose access to the main residence exemption and be subject to full CGT.

The 12-month ownership discount and other exemptions

The 12-month ownership discount allows property owners to reduce their CGT liability by 50% if they hold the investment property for more than 12 months before selling. This discount is applied to individuals and helps lower your CGT by reducing the capital gain included in your taxable income.

In addition to the 12-month ownership discount, there are other CGT exemptions to consider:

• Main residence exemption: Avoid CGT on your PPOR, this is a key benefit for homeowners.
• Six-month rule: Allows you to hold two principal places of residence for up to six months without triggering CGT.
• Partial main residence exemption: Reduces CGT liability based on the time you used the property as your PPOR compared to when it was an investment property.
• CGT main residence exemption: Full exemption on assessable income from the sale of a property used solely as your main residence.

Years lived in vs. years rented: How do partial exemptions work?

When a property is both your PPOR and an income-producing asset, you may qualify for partial CGT exemptions. This is calculated based on the proportion of time the property was your main residence versus the time it was rented out. Only the period when the property was rented or used for income-producing purposes is subject to CGT.

Key points:

• Years lived in: The property is exempt from CGT during the time it was your PPOR.
• Years rented out: You pay CGT only for the period the property was used as an investment property.
• Proportional method: CGT is applied based on the ratio of years rented to total ownership.

For example, if you owned a property for 10 years, lived in it for six years and rented it for four, you would only pay CGT on the four rental years. This partial main residence exemption helps reduce your capital gains tax liability and taxable income, which is ideal for investors looking to maximise tax deductions on real estate transactions.

How can I reduce the Capital Gains Tax on my property?

There are a few things you can do to lower the CGT on your investment property. These include raising the cost base and selling it at the right time:

• Increase the cost base: By adding eligible expenses, you reduce the overall capital gain. These expenses include:
  • Purchase price
  • Renovation costs
  • Legal fees
  • Stamp duty
  • Maintenance costs
  • Agent commissions
• Timing your sale: Sell within the 6-year rule window to leverage the main residence exemption and reduce your capital gains tax liability.
• Depreciation and tax deductions: If you have claimed depreciation on your property, ensure these adjustments are factored into your cost base.
• Assess property value before selling: Knowing the market value of your property and timing your sale in a favourable market can also help manage your financial situation by reducing the capital growth subject to CGT.

Deciding when and how to treat your rental property as your main residence

The timing affects both the market value of your property and potential capital gains. To reduce your capital gains tax liability, consider:

1. Market value: Assess the property's market value at different points to determine the potential capital gain.
2. Capital growth: Evaluate how long you've held the property and how much its value has increased.
3. Personal financial situation: Ensure that the decision aligns with your broader investment strategy and financial situation.

When you're ready to make the election, declare the property as your main residence in your tax return filed with the ATO. This allows you to apply the 6-year rule, taking advantage of tax exemptions and reducing your CGT burden. For example, switching your rental property to your main residence before selling can help you qualify for the main residence exemption, minimising CGT on the sale.

FAQs

What happens if the 6-year limit is exceeded?
You'll owe CGT on the portion of time beyond six years of renting.

Do I pay CGT when I sell my investment property?
Yes, unless you qualify for exemptions like the 6-year rule or 12-month discount.

When do you pay CGT on investment property?
CGT is due in the financial year you sell the property and must be reported on your tax return.

Can you have two primary residences in Australia?
No, but the six-month rule allows two properties to be treated as main residences for up to six months.

Does the 6-year rule apply to two main residences?
No, it only applies to one property at a time.

Can foreign residents use the 6-year rule?
No, foreign residents cannot claim the main residence exemption or the 6-year rule.

How much CGT do I pay on $100,000?
After the 50% discount, you'd be taxed on $50,000 at your marginal rate. At 32.5%, you'd pay $16,250.

What if you're away from your PPOR more than once?
The 6-year rule resets each time you move back in.

How can I reduce my CGT?
Increase the cost base with expenses, use the 6-year rule or apply the 12-month discount.

Maximise your CGT savings with the 6-year rule

Utilising the 6-year rule and other CGT exemptions, like the main residence exemption and 12-month ownership discount, can significantly reduce or eliminate your CGT liability when selling your investment property. These strategies offer great tax-saving opportunities for property investors, but it's essential to tailor them to your financial situation.

Consult Wilson Porter for expert guidance to ensure you make the most of these benefits.