Making your home a rental

It’s called the six-year rule and it’s so commonly bandied about that it has its own folk law. Australian Property Investor magazine takes a look at the issues that will affect you if you decide to rent out your home.

story Julia Hartman

The first major point of the six-year rule is that you cannot apply it until after you’ve lived in the house. Factors the Australian Tax Office (ATO) considers relevant in determining if you have lived in a house include your address on the electoral roll, where your family resides, whether utilities are connected in your name and where your personal effects are kept.

Assuming you’ve lived in the home, you can rent it out for up to six years at a time and continue to give it your main residence exemption. Of course during this time you cannot exempt another property as your main residence even if you’re living in it.
Couples are only entitled to one main residence between them. If you move back in after renting the property out for six years and then move out and rent it again you’re entitled to another six years and so on.

If you vacate the property for more than six years in a row you can still use the six-year rule to exempt it for the first six years.
Let’s assume you have “property one” which you’ve lived in since you purchased it and “property two” which has been a rental property since you purchased it. Due to urban renewal that has just begun around property one, you expect it to make better capital gains and earn a better rent than property two. So you decide to move from property one into property two. By leaving your main residence exemption with property one, in six years’ time you could sell it and not be subject to any capital gains tax (CGT) on it.

If you ever sell property two you will be subject to CGT on it for the period you owned property one. You can move your main residence exemption across to property two as soon as you have sold property one. You don’t have to move back into property one before you sell it, nor do you have to justify to the ATO why you arranged your affairs that way, it is your choice.
You don’t have to decide which property is covered by your main residence exemption until you prepare your tax return for the year you sell property one. If you intend to live in property two for the rest of your life, the sleeping CGT liability on it will never bother you or your heirs.

If property two is your main residence when you die it makes no difference that at some time in the past it was rented. Your heirs are still entitled to all the CGT concessions that would have applied if it had been your main residence all the time you owned it. This means they pay no CGT if they sell it within two years of your death, or, if they keep it, their cost base is simply the market value at the time you died.

Another name for the six-year rule is the absence rule. If you are not absent, you are not entitled to use it.

So if you rent out part of your home, for example a granny flat or rooms in the house, the six-year rule cannot apply. Instead your main residence exemption is limited to the part of the property you use personally.

If this is the first time you’ve earned income from your home, it will cause your cost base for your whole home to be reset at the market value at the date it first started earning income. This can be the case even if you are just renting out a room in your home.

Scenarios

There is a case of parents who bought a family home but only ever stayed there when on holidays in Australia. They worked overseas and their adult children occupied the house. The parents could not give it their main residence exemption as they were considered to be residing overseas for all of the period of ownership and as their children were over 18 but not on the title deed, they could not cover the property with their main residence exemption either.

As you can see from the above it’s not hard to wind up with some CGT applicable to your home. But while CGT may apply, keeping good records can help you minimise its effect.

Section 110-25 of the Income Tax Assessment Act 1997 applies to properties purchased after August 20, 1991. The CGT cost base for these properties includes holding costs, such as interest, repairs, rates, insurance and land tax that are not otherwise deductible.

It’s important to note that holding costs cannot be used to create a capital loss. Holding costs increase the cost base before it is apportioned between exempt and non-exempt days so the holding costs while you are living there can reduce the gain incurred while you are not.

This is best explained by way of an example. Let’s assume a family lives in a house for 10 years and rents it out for 12. The house costs them about $5000 per year in holding costs. During the 12 years it was rented they claimed a tax deduction for the holding costs so they cannot be used to increase the cost base but the holding costs while they lived there can.

Assume the property originally cost them $100,000 including purchasing costs such as stamp duty. After deducting selling costs, they received $200,000 from the sale. Their cost base would be $150,000 (100,000 + ($5000 x 10 years)) after adding in the holding costs for the 10 years they lived there. They have made a gain of $50,000 which is divided by the 22 years they owned it and multiplied by the six years it was not covered by their main residence exemption. So only $13,636 ($50,000 / 22 years x 6 years) of the gain is not exempt.

After applying the 50 per cent CGT discount they are only taxable on $6818.

Note, this would not be the case if they first rented the property out after August 20, 1996. Main residences that are first rented out after August 20, 1996 automatically have their cost base reset to the market value at the date they are first rented out.

In the example above, the holding costs incurred after the reset cannot increase the cost base because they would have been claimed as a tax deduction and the holding costs before the reset are now disqualified.

Nevertheless, the six-year rule would apply to exempt half the time it was rented out. So if, say, the market value was $140,000 and after deducting selling costs they netted $200,000 on the sale, they have made a gain of $60,000 – half of which is subject to tax as they had rented it out for 12 years straight so could only use the exemption for six years. They also qualify for the 50 per cent CGT discount so the taxable gain would be $15,000.

If your cost base is reset to the market value when your house first produced income but you move back in, make sure you keep a record of all your holding costs from that point onwards as they can be used to increase the reset market value cost base.

Note, all of the above is only applicable to properties purchased after September 19, 1985. CGT does not apply to properties purchased before that date unless they change hands or significant money is spent on them.

Julia Hartman is a CPA, registered tax agent and founder of BAN TACS Accountants Pty Ltd.