Have you ever wondered how you could be a real estate investor and avoid paying capital gains tax? The “six-year rule” might be your answer.
To paraphrase the late Kerry Packer, anyone who isn’t trying to minimize their tax bill should have their head examined. Depending on your level of income, capital gains tax or CGT when selling your investment property could cost up to 45% of the profits. If you made $200,000 in profit, that’s $90,000 straight to the taxman.
However, what if you could avoid such a tax? This is where the six-year CGT rule can come in handy – but it’s not necessarily your “get out of jail free” card.
In this article…
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What is the six-year CGT rule?
Also known as the “no-show rule”, this rule essentially means that you can treat your investment property as your principal place of residence (in a tax sense) for up to six years.
Under this rule, you can use the property to produce income such as rent for up to six years without attracting CGT for those six years if you sell it. The rule can be used indefinitely if it is not used to generate income, for example if it remains empty or if you only use it as a personal vacation home.
The main catch is this: you can’t consider any other property your primary residence, except for up to six months if you move. This basically means that if you want to live elsewhere in the country for continued and official capacity, you will need to rent or have generous friends or family.
Mark Chapman, director of tax communications at H&R Block, told Savings.com.au this is an important rule for homeowners who may need to leave their homes for a period of time.
“A landlord may find employment overseas or in another state for a period of time and may elect to rent out his property while he is away, fully intending to return at the end of his contract – that would not be all just not fair to apply the principal residence exemption in such circumstances,” Mr. Chapman said.
What is an APPR?
To satisfy the Australian Tax Office under the six-year rule, the residence must have genuinely been a PPOR, or principal place of residence. The accommodation must first have been your main residence, and to benefit from the CGT exemption you must have actually ceased to live there.
Mr Chapman said that was the main caveat.
“You have to remember that the absence rule only applies when the property is genuinely empty, whether the property is being used to produce income,” he said.
“If you’re staying in the house but renting out part of it — say, on Airbnb — the away rule doesn’t apply because you’re still living there.
“Attempts to ‘game the system’ are a surefire way to attract the attention of the Australian tax authorities.”
Small businesses and homes used as income before moving
This is where it gets tricky. If you work from home as a small business owner, such as a masseuse, consultant or other profession, any part of the home used for that profession will be subject to CGT.
For example, if you estimate that 25% of the home was used for the business, 25% of the total capital gain will be subject to CGT when you sell the house, while 75% will not be under the rule of six. years.
For example, if you realize a capital gain of $100,000 after two years of ownership, $25,000 will be subject to CGT, although with a 50% rebate for holding the asset longer than one year . So if your top marginal income bracket is 45%, 22.5% of $25,000 equals $5,625 to pay in capital gains tax.
What happens if you move more than once?
For a new six-year period to trigger, the owner must move back into the property and treat it as their principal residence before it again produces income.
To quote the ATO: “If you are absent more than once during the period you own the property, the six-year period applies separately to each period of absence.”
Mr Chapman said the cycle can continue indefinitely.
“If you rent the property for, say, five years, then move back in for six months, then rent the property again for another five years, your entire capital gain will be tax-free,” said he declared.
“The ‘six-year rule’ resets each time you return to the property and live there as your primary residence. This means that if you move back in and then move out later, renting the property out to tenants, you get a further six-year absence period during which the principal residence exemption is protected.
What happens if the six-year limit is exceeded?
Any time spent producing income on your PPOR beyond the six-year threshold will be subject to CGT. For example, if you sell the house after seven years, you will be subject to CGT based on that additional year provided you have labeled it as your PPOR for those first six years.
Case Study – Saving on CGT
Lou Pole bought his Brisbane PPOR in 2010 for $500,000. In 2012, he has to take care of his sick sister in Perth. He moves in with her and luckily for him, he doesn’t have to pay rent.
He decides to rent out his home in Brisbane, but continues to treat it as his PPOR for tax purposes.
Three years later, he decides to sell the house. He sells it for $700,000 – a gain of $200,000.
His top marginal tax bracket is 32.5c on the dollar, so without the six-year rule he would have been liable for $32,500 in capital gains tax. But thanks to the six-year rule, not a penny is taxed on that profit.
Lou Pole decides to use this “saved” money to buy his sister a Mazda 3 – nice brother.
Six-year CGT rule – advantages and disadvantages
The most obvious advantage is that you can avoid paying a lot of taxes, while the obvious disadvantage is that you might be restricted in where you live if your property is considered your PPOR.
Save on taxes: The rule is designed to limit prohibitive costs when leaving a property, even temporarily, such as a stay abroad or when making a new placement.
Flexibility: Suppose you need to move to another accommodation for a temporary period, either to care for a sick loved one or to complete a temporary internship. The six-year rule allows you to lease your PPOR and not attract CGT if you sell within that time.
You may need to rent: You cannot buy another house and classify it as your PPOR and still take advantage of the six-year rule. This means you may have to rent – unless you have very generous friends and family who will let you live with them for up to six years. If you are a tenant, you will need to weigh the costs against the potential money saved on CGT.
Rigidity: While this is a potentially handy option if you really have to leave your home for a short time, if you are moving specifically to take advantage of this CGT rule, the hurdles that come with investment property and then finding your own place to live could be a headache.
Photo by R Architecture on Unsplash
For tax advice relevant to you, visit the ATO or consult an independent tax adviser.
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