Tax Tips/Strategies #2 | The Most Exhaustive & Comprehensive Guide to Six Years of Absence Exemption
Updated: Nov 4, 2021
The Most Exhaustive & Comprehensive Guide to Six Years of Absence Exemption
One of the most common Capital Gains Tax (CGT) Exemptions is treating property as a principal place of residence (PPOR). As we all know, there is usually no tax due on the selling of a family home (provided the land is under 2 hectares).
This rule builds on the PPOR exemption, allowing taxpayers who no longer lives in their primary residence to earn rent from it for up to 6 years while still treating the property as their PPOR. The conditions required include:
·The taxpayer does not create a new property as their primary residence during the period they are out of the PPOR
At any given time, each taxpayer is only allowed to claim one property as their primary residence.
To be eligible for the full main residence CGT exemption on selling a home, the taxpayer must have made the property their primary residence as soon as possible after purchasing it.
CGT Exempt Assets
Assets eligible for CGT Exemption include:
Any assets that were acquired before September 20, 1985
Your main residence
Depreciating assets in an investment property
The Temporary Absence Rule
When an individual resides, occupies and lives in a property as their home, it is a principal place of residence (PPOR). The owner is excluded from CGT if a property is called an owner's PPOR. Restrictions apply to properties on land over two hectares.
A property may be used as either a primary residence or a rental investment when it is first purchased. The essence of the property's first use will determine how the capital gain is measured when it is sold for a profit. When a person's primary residence begins to generate rental income, he or she is liable for Capital Gains Tax (CGT). However, this is where the 6-year temporary absence rule kicks in.
For the period that a property is occupied as a primary residence, it is excluded from capital gains tax (CGT). If a property is sold within six years of first being leased out, it will continue to be excluded from CGT. Only if no other property is designated as the primary residence is the exemption valid.
While a person's residence is normally subject to CGT from the day it generates revenue, this provision enables them to continue to treat it as their main residence for up to six years exemption benefits after that date.
By choosing to treat the property as the person's primary residence for CGT exemption purposes, the person's primary residence will remain CGT-free (i.e., tax-free) for up to six years.
The ATO recognizes that there are various special situations outside the property owner's control, and there are several explanations why you might not be living in your property for some time.
The capital gains tax property six-year rule would also apply to homeowners who want to earn some extra cash during the period they are unable to live in their house. The six-year exemption period begins again when the dwelling is reoccupied as the primary residence. As a result, another six-year period of exemption is open.
Example of the 6 year temporary absence rule
Suppose you purchase a home in 2003 and remain there for four years, after which you got a job across the country in 2007. Moving out of your house becomes your only option, and then you decide to rent it out.
Your house stays rented out till 2011, after which you decide to move in again and stay there until 2014 when you got another job across the state. You are free to step out once more and take advantage of another six-year absence period.
Since your property has been classified as your primary residence for CGT purposes in this period, you are excluded from paying CGT on its sale.
You're probably wondering when the main residence will begin and end for CGT purposes on property investment
This is a common issue. How is it handled when you quit staying in your home and then sell it? The six-year exemption rule kicks in at this stage.
If your property is no longer considered your primary residence – that is, if it no longer meets the conditions stated above – it is no longer considered your primary residence for CGT purposes.
The ATO gives some flexibility. You can treat your property as your primary residence for CGT purposes for up to six years after you've moved out. The six-year absence law also referred to as the six year exemption, governs this situation.
Depending on what happens after you leave this premises, this time will vary. It can be your primary residence for up to six years if you rent it out. If you don't rent the house, it can serve as your primary residence for as long as you want. You can use this exception as many times as you like.
Methods to Avoid Incurring Capital Gain Tax (or as much)
Extending the exemption by reoccupying the property as the main residence at regular intervals may result in a tax-free gain on sale if all other conditions are met.
Converting a second home or rental property to a primary residence is another way to reduce Capital Gain Tax once your original PPOR is sold.
Cost basis adjustments can also help to reduce the benefits. Include fees and costs associated with the purchase of the house and home improvements and upgrades to raise the cost basis. As a result of the increased cost base, capital gains are reduced.
The 6 Year Rule and Non-Resident Expats
Non-tax residents can buy rental properties in Australia for the same price as tax residents. The purchase price, stamp duty (a state-based tax), and legal costs for transferring the property from the seller to the buyer are all included.
Wherever the property is leased, positive net rental income is taxed. Rental losses may be carried forward indefinitely to cover potential profits. Any capital gain gained from selling the property can also be used to cover the losses.
Non-resident income tax rates are marginally higher than resident income tax rates. When the land value reaches a certain threshold, a state-based tax known as land tax is due.
The rate of land tax varies by state; in New South Wales, it is 1.6 percent of the land value, with a $755k threshold (2020-21). Over this point, the land value becomes taxable.
The main distinction is that non-residents must pay taxes on the first $18,200 of wages, while residents do not. Residents pay just 19 percent tax on income between $18.2k and $37k, while non-residents pay 32.5 percent.
The government proposed drastic new reforms, including eliminating the "primary residence exception" and the six-year temporary absence law.
The proposal aimed to impose a full capital gains tax on non-resident Australian expats (and non-residents in general) who sold their homes while living abroad. In practice, this meant that there would be no deductions for non-resident expats, and selling their home would almost certainly result in a large capital gains tax bill.
The Treasury Laws Amendment (Reducing Pressure on Housing Affordability Measures No. 2) Bill 2018, which proposed scrapping the non-resident expats' "primary residence exemption," passed the parliament on 12 December 2019 and came into effect 1 July 2020.
This means expats are up for a hefty tax bill if the don't meet the exceptions. The exceptions are major life events (divorce, terminal illness or death (themselves, spouse or kids under 18), resident held continuously before 9 May 2017 (contract to sell must be before 30 June 2020),if not held for six years before 9 May 2017 they cannot be a foreign resident for six continuous years and a life event must occurs.
Pros and Cons of CGT
From individuals who have to abandon their residence due to a new work location to regular homeowners and even property investors, the benefits the CGT six-year absence rule provides are quite multifold.
The most common should be how the exemption provides homeowners the opportunity to make profitable ventures out of what would otherwise lay unused in the event of their prolonged absence. Even vacancy in ACT and Vic would mean you are liable for land tax so this would allow you to offset this expense.
Individuals also do not have to fret in anticipation of the end of the six-year exemption period as it can easily be renewed so long as the property is reoccupied as the main residence before the elapse of the sixth year. While this renewal isn't overt, discerning individuals can leverage it by simply moving back before the expiration of the six years, reinstate it as the main residence, and then beginning the cycle of letting it out once again to unlock a fresh exemption period. This is especially the case post covid where it is easier to Work From Home (WFH) so you can take advantage of the loosening of your flexibility.
The flexibility of this exemption is another positive aspect as you can choose to reoccupy your PPOR at any during the six years to reset this exemption to suit your needs.
The ability to stack tax exemptions/loopholes is another powerful aspect of this strategy. Used in combination with debt recycling, depreciation schedule (tax tips/strategy #3), security for another income generating asset and leverage can speed up the wealth generation that you can get compared to shares/ETF portfolio.
Unlike the preservation age for access to super which can be changed, this rule is likely to be grandfathered for any changes to this exemption. Also unlike superannuation, even if the policy change affects you, you can decide to sell your PPOR but there is nothing you can do if preservation age is extended.
Thousands get saved on taxes per year as this process provides an avenue for citizens to legally cut down on tax expenses: a win-win for all parties involved.
With so many benefits, which are evident when the six-year CGT exemption applies, one wonders if there could be possible downsides to it, and indeed there are. To begin with, there's the problem of dubiousness. When a property generates income, the owner can treat it as a primary residence for six years, which can further be extended every time the property ceases and once again resumes income generation. Homeowners can then decide on this shrewd method which defeats the purpose of the rule.
Another difficulty that arises would be applying the six-year exemption to a property that had existed pre- CGT. While the land itself is rightly not subject to the tax law, the enhancements made on it post-CGT should be, but the exemption may be applied in ways that would make the gains evadable.
It should also not be forgotten that not only homeowners get to benefit from the exemption. Property investors and even renovators who have met the requirements are eligible, and one can only imagine what that means in terms of revenue for the state.
There is a real risk of policy change in the near future given it was previously discussed by politicians whether this exemption should be scrapped. Existing users of the exemption may risk having the multiple period of the six years exemption being removed or the entire exemption removed (low risk). Either way, they can elect to sell the PPOR if it no longer suits their need.
Getting the Best of the Six-Year Rule
The single maximum period of absence is six years, after which a pro-rata tax is applied. These six years can be reset by returning and then leaving again, as long as the return establishes a permanent main residence and is not only a temporary stay. If s118-192 applies, it is also important to understand because it will reset the cost base in some, but not all cases. In certain cases, if s118-192 isn't used, there might be an option to apply personal non-deductible costs to the overall cost base before the pro-rata.
There are currently no restrictions on how many times a property owner can do this as long as each absence is less than six years. If a property owner does not rent out the property but then moves out, they may be eligible for a CGT exemption for up to 6 years. For the time being, if a property owner chooses one of the options above, they are unable to assert any other property as their principal place of residence that overlaps with the period of the original one.
If the taxpayer re-establishes the property as their primary residence after any absence, the 6-year timer will reset.
Suppose a taxpayer is absent from their PPOR but does not receive any income from rent. In that case, they will continue to treat the property as their primary residence indefinitely if they follow the same conditions as above. The 6-year absence rule only applies if the property generates income.
Key Considerations for the Six Year Rule
A lot of people often wonder if the rule can be used on more than one residence. Every taxpayer was entitled to a Principal Residence Exemption (PRE) before December 31, 1981. This means that if a husband and wife owned a house and a cottage, each spouse may designate one of the properties as their primary residence and receive the full PRE for each. This may be different if they owned their own property prior to marriage/de-facto union as defined by the law. Please seek advice from your accountant as always when considering deploying my tips but also to check on this.
However, this is no longer allowed. Each family unit is allowed to designate one property as its primary residence each year under the Income Tax Act. The taxpayer, spouse or common-law partner, and any children under the age of 18 make up a family unit.
They can seek a capital gain exemption for any or all the years they stayed in the house under the PRE. They'll have to split the exemption.
Let's explore an example to further understand how the principal residence rule works.
A certain lady owned a house in the city that she bought for $300,000 in 2004. She buys a cottage for $240,000 in 2009. In 2013, she sold both properties for $600,000 in the city and $400,000 in the cottage. What is the best way to put her principal residence exemption to work for her?
She uses the exception on the city home for these years since it was her only property from 2004 to 2008. If the lady owns two properties between 2009 and 2013, she must choose which one to use the Primary Residence Exemption.
Capital Gain Calculations
Home in the city
Proceeds of disposition $600,000
Gain per year $300,000 / 10 years = $30,000
Proceeds of disposition $400,000
Gain per year $160,000 / 5 years = $32,000
Since the cottage has a higher annual capital gain, it will make sense to designate it as the primary residence from 2010 to 2013. Since the formula is 1+the years allocated for the exemption, that's four years.
This helps her to avoid paying capital gains tax on the cottage's sale. For the years 2004 through 2009, she will designate his city home as her primary residence, allowing her to defer $210,000 in capital gains.
[(1+6)/10] x 300,000 is the calculation. As a result, her capital gain will be $90,000, with $45,000 of it being taxable. This plan would save her more money in taxes than just designating her city home as her primary residence for the entire year.
The length of time a person must live in a property before it becomes their primary residence is a frequently asked question. The legislation does not specify any minimum requirements. But there is a risk that you may be asked to provide evidence that it wasn’t a temporary stay. Some suggestions to show your attempt at re-establishing the place as a PPOR includes keeping records of your utility bills, address on license, address on bank statements.
This clause cannot be used to claim a property unless it is your primary residence.
But when you finally sell one of them at that stage, you have to determine which one to treat as the main residence as you can only count one property as the main residence at any one time.
The Six Years Approaches
You may opt to treat the house as your main residence for up to six years after you quit living in it if you use it to generate income (for example, if you rent it out or it is available for rent). The 'home first used to generate profits' rule does not apply if the dwelling is completely excluded due to your decision.
If you rent out your home for more than six years, you will be subject to the 'home first used to produce income' law, which means you are presumed to have purchased the home at its current value when you first used it to generate income. The law does not apply to you if you use your home to generate income from the moment you buy it. The 'home first used to generate income' rule does not apply if you choose to treat a dwelling as your main residence after moving out, and the dwelling is entirely excluded.
Let's look at some examples to explain further.
Example 1: Residence was used to generate income within six years
Michael bought a house in Brisbane four years ago and has lived there ever since. For the entire time he has owned it, it has been his primary home.
Since that time, he's been given a two-year job placement in Perth. He accepted the role and relocated to Perth, where he chose to live with his cousin. As a result, he never considered any other home to be his primary residence. Meanwhile, to supplement his income, he has agreed to rent out his home while abroad.
He agreed to permanently relocate to Perth after two years and sell his home in Brisbane. He was able to sell the property and assert the CGT exemption by using the capital gains tax property six-year law.
As a result, he was exempt from paying capital gains tax.
On July 2, 1994, Mr. John signed a contract to purchase an apartment in Sydney, which he used as his primary residence. On January 1, 1995, his employer moved him to Brisbane, and he signed a contract to buy a house there.
When Mr. John was stationed in Brisbane, he rented out his Sydney apartment from January 2, 1996 to December 30, 1999. On December 31, 1999, he agreed to sell his Brisbane home, and the resident of his Sydney apartment relocated.
When he sold his Brisbane home after that, he chose not to use the main residence exemption, so the capital gain had to be recorded on his tax return that year.
On January 3, 2000, Mr. John's employer moved him from Brisbane to Melbourne for four years, and he signed a deal to buy a townhouse in Melbourne. He did not return to his Sydney apartment at this time.
On March 3, 2000, he rented out his Sydney apartment for the second time, this time for two years.
On February 25, 2002, the tenant in his Sydney apartment moved out.
On December 30, 2002, Mr. John sold his Melbourne townhouse. He chose not to use the main residence exemption when selling this property. On December 29, 2003, he returned to his Sydney apartment and made it his primary residence once more.
On February 20, 2020, Mr. John signed a contract to sell his Sydney apartment.
The amount of the gain that is assessable is determined as follows: If the capital gain on the sale of the Sydney apartment is $250,000, the amount of the gain that is assessable is calculated as follows:
Ownership of the Sydney apartment lasted from July 5, 1994, to February 20, 2020, a total of 9,740 days.
Following Mr. John's departure, the Sydney apartment was used to generate income at various times:
January 2, 1996, to December 30, 1999, = 1,824 days
March 3, 2000, to February 25, 2002 = 725 days
Total = 2,549 days
First six years, the Sydney apartment was used to produce income:
2 January 1996 to 30 December 1999 = 1,824 days
3 March 2000 to 25 February 2002 = 725 days
Total = 2,191 days
Income-producing period exceeding six years after Mr John stopped living in it:
2,556 − 2,191 = 365 days
Proportion of capital gain assessable:
$250,000 × (365 ÷ 9,740) = $9,369
Mr. John will measure his capital gain using either the indexation or discount methods since he purchased the property before September 21, 1999, and sold it after that date, and he owned it for at least 12 months.
Since Mr. John used the apartment to generate income before August 21, 1996, the 'home first used to generate income law' does not apply.
Understanding Interest Deductible
Whether or not you borrowed money to buy your home, the interest deductibility test applies. You would use that if you took out a loan to buy the house.
If you run a company or practice out of a portion of your home, you will be able to subtract a portion of the interest on the money you borrowed to buy the house if a portion of the house is designated solely for business purposes and is marked as such, and that portion of the house is not easily adaptable for personal use.
If you rented out a portion of your house, you would be able to subtract a portion of the interest you paid on the loan. If someone else uses part of your home to generate income and you earn no income from that person, you can still get a full main residence exemption.
You can't get a CGT exemption for a portion of your home that you set aside and use solely as a place of business if you don't demand a deduction for interest on your home loan. You can't have interest in the cost base if you're eligible for a deduction but don't use it.
Certainly, the capital gains tax is here to stay, and property owners would be left with no choice than dealing with it. It would therefore be of the utmost advantage to familiarize oneself with the conditions necessary to make the most of it. The subject of the six years of absence and CGT exemption would foremostly require a proper understanding of the notion of "primary place of residence" and what qualifies a property to attain that status. With that in place and the pros and cons weighed, one would certainly make informed decisions regarding their CGT.
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