So, what do you need to know when your beloved family home, first apartment, or any primary property becomes an investment property? We have broken it down into three categories you can consider, these are: capital gains, interest deductions, and general rental expenses.
Capital Gains requirements for personal homes turned rental properties.
One of the first but most commonly overlooked things to consider is the capital gain implication of deciding to rent your primary residence. This often gets overlooked because the implications of capital gains are not obvious until the property is eventually transferred or sold. Additionally, there is a little know tax provision referred to as the ‘6-year rule’ that can be advantageous for taxpayers.
Let’s start with the requirements. If you are eventually required to pay Capital Gains Tax (CGT), it will only need to be paid on the difference between the properties value when it was first used to generate income and when the property is sold. This means two things; 1 you will not need to pay CGT on the change in market value that accrues while you are living in the property; and 2, you will need to know what the market value of the property was at the time it was first made available to rent. The latter means that you will need to have the property professional appraised at the time you move out of the property. If you decide to list the property through a real estate, this might be the perfect time to have the that real estate appraise the property at the same time. This will give you what is known as the cost base, now the property is defined as an income generating investment.
Note: Appraisals can be done retrospectively if you forget to get a valuation or lose it before you sell.
But remember! The previously mentioned ‘6-year rule’ will apply because the property was once your primary residence. The ATO explains the 6-year rule by saying:
“If you use your former home to produce income (for example, you rent it out or make it available for rent), you can choose to treat it as your main residence for up to 6 years after you stop living in it.”
This means that the benefit of not having to pay CGT on a primary residence will continue to apply to the now rented property for up to 6-years. What’s more, the 6-year rule resets each time the property because your primary residence. An example from the ATO’s website explains the principle nicely:
“Jez bought and moved into a house in 2003:
- In 2012, he had to move for work, so he stopped living in the house and rented it out for the next 5 years.
- In 2017 he moved back into the house and treated it as his main residence for 2 years.
- In 2019 he again moved and rented the house out, this time for 3 years.
- In 2022 he sold the house.”
In this scenario, because Jez never used the house to earn income for longer than 6 years between occupying it himself, when he sells it in 2022, it will be as if it was his primary residence the entire time he owned the home. Consequently, he will not be required to pay CGT on any of the sale proceeds even though he the property earned him money for a total of 8 years.
If, however you do exceed the 6 years you will still benefit for the rule. Let’s say Jez never moved back in and just left the house empty between 2017 and 2019. In this case Jez would be required to calculate the total capital gain by working out the difference between the cost base (professional valuation) from when the property was first rented in 2012 and the gain from the property sale in 2022. The total gain would then be reduced to account for the maximum 6 years of the ‘6-year rule’ by reducing the capital gain by the equivalent of 6 years by apportioning the equivalent number of days accordingly.
Note: You cannot claim the main residence exemption on any other property during the period you claim the ‘6 year rule’
Owner occupier interest turned rental deduction.
Now that you have moved out and the property is available for rent, any interest charged on loans outstanding might be able to be claimed against the income the newly rented property generates. But not all interest can be claimed. The rule when determining if interest is or is not tax deductable is to consider the extent that the borrowing is used to acquire income-producing assets, in our case rental property.
That sounds great but what does it mean?
It means that only the interest on money loaned to buy or renovate the home will be tax deductable. This has implications and limitations to those who have or want to refinance. It means if you have in the past or intended to refinance a loan on your family home, you will not be able to claim the interest on those funds loaned for personal use when it becomes a rental. In practice this might mean that if you have refinanced for a holiday or car in the past, you will have to work out what percentage of the remaining loan was for those purposes and reduce your interest deduction by the same amount. Likewise, if you refinanced to free up money for your new home, you will need to reduce you interest to account for the refinanced amount.
Note: Interest relating to loans for your new home are in no way deductible.
At what point do expenses stop being personal and start being deductible?
The simple answer to that question is at the time the property is genuinely available for rent. This is the point the property is both liveable and advertised. At this stage it is important to keep records of all property expenses including items like body corporate, council rates, insurance, interest on loans, repairs & maintenance and water charges so they can be claimed as tax deductions.
What about the expenses incurred in the time between when I move out and when the tenant moves in?
There is often a small window between the time you have moved out of the property and the time the property is genuinely available for rent. Typical expenses in this window might include having the property cleaned, and any repairs and maintenance necessary to make the property rentable. These sorts of expenses will not be able to be claimed against the rental income because they were incurred before the property was an income generating investment. However, you should keep a record of these expenses as they can be added to the cost base of the property to lower any future CGT obligations you might have.