Capital Gains Tax Explained
What you need to know about Capital Gains Tax and how it will affect your property goals.
When dealing in real estate, the term Capital Gains Tax (CGT) gets thrown around a lot, and for those new to home buying and investing, it pays to wrap your head around what CGT is because it could potentially affect your short and long-term property goals.
Here we explore the basics of CGT; what it is, how it's calculated, whether it applies to your main residence and that all-important Six Year Rule. Let's dive in.
What is Capital Gains Tax?
When you sell your property, you either make a capital gain or capital loss, which is the difference between what you paid for the asset and what you sold it for. When you make a profit from the sale of your property, you're required to pay the Government Capital Gains Tax.
CGT also applies to any foreign assets, such as investment properties you own, but not to your primary residence.
How much Capital Gains Tax will you have to pay?
Unfortunately, the answer isn't as simple as what you would like it to be. CGT is not a separate tax, it forms part of your income tax, and it's only payable in the year you sell your property. It's tricky to calculate how much CGT you'll have to pay because it depends on your personal tax bracket for that year you sell your property. Which means it could significantly increase the tax you need to pay.
To avoid being caught out, engage a good taxation accountant who can guide you with how much you need to set aside.
Your main residence and Capital Gains Tax
Generally speaking, your home (main residence) is free from CGT. But it's important to note that you can only have one residence for tax exemption at any given time. According to the Australian Taxation Office (ATO), a property is considered a main residence if;
- you and your family live in it
- your personal belongings are in it
- it's the address your mail is delivered to
- it's your address on the electoral roll
- services such as gas and power are connected.
The ATO goes on to explain that the main residence exemption is not based on one of these factors alone. The weight given to each varies depending on individual circumstances. The length of time you stay there and your intention in occupying it may also be relevant.
The Six Year Rule – when your main residence becomes an investment property
It's very common for first homes to become an investment property and for people to have an investment property which then becomes their home. In these scenarios, propertyupdate.com.au explains that if you had a tenant before you moved in, then the Government will spread the CGT from the time you held it and the number of days you had a tenant. Then the period you were living in it as a main residence will fall under the main residence tax exemption.
They go on to explain that if you moved into the property from day one, then the whole period is CGT free until it becomes an investment property. But here's where it gets interesting. If you move out of your main residence after the initial six months of being a homeowner, the following six years of capital growth will be CGT free. It's called the Six Year Rule.
The Six Year Rule ultimately allows you to use your property investment, as if it was your main residence for up to six years, while you rent it out. It also allows you to sell your home within the six-year period and be exempt from CGT, similar to if it was your main residence. Suppose you're away for more than six years, then you will pay CGT on the date from when the six-year period lapses.
There is so much more to CGT, and depending on your individual situation, how much you end up paying varies widely. For more detailed information, visit www.ato.gov.au/general/capital-gains-tax/, and always seek professional advice from your taxation accountant.