Question

On March 1 2012 Philip inherited a property in inner Sydney at 151 Temple Street from his Aunt. The property had been used for commercial purposes but as the area was central to his job as an interior designer he decided to move in immediately and renovate to convert to residential accommodation. The property was valued by the Aunt’s deceased estate at $370,000 Philip borrowed $100,000 on 1 April 2012 at fixed interest of 5.5% per annum payable over twenty years to finance the renovation. In September 2014 Philip married Kim, a plumber, and they resided in the now completely renovated property, paying out the loan early on 1 April 2016. On 1 July 2017 they purchased jointly an adjacent property, 153-155 Temple Street, for $850,000, which was significantly larger with the view to develop it into two residential properties. They purchased this property using savings of $30,000 and a loan of $960,000 (legal and other costs to purchase were $40,000 and the balance was borrowed to finance the first stage of the renovation) and using the equity in the renovated property at 151 Temple Street which was valued to obtain the loan at $800,000, as further collateral. They again opted for a fixed interest rate, 4.7% per annum with the loan maturing in 30 years. They continued to live in the original property until they had completed the first phase of the renovation at 153 Temple on 1 August 2019. The renovation had come in on budget at a cost of $100,000. They were so pleased with the renovation and the larger residence it offered they decided to move from the original property on 1 August 2019 and rented 151 Temple for $759 per week to a cousin from 7 August 2019. The rental payment was approximately 10% below market in exchange for the cousin providing labour for the renovation of the remaining property. Despite the rental income they are concerned that the next phase of the renovation is taking too long and are considering selling a property to raise funds quickly to complete the work. A local real estate agent has indicated 151 Temple St could be sold for $1 million and the more recently renovated 153 Temple St would sell for $1.3 million.

Required - As per Australian Taxation rules, Advise Philip and Kim of the tax implications of selling either property and any amount that would be included in the calculation of taxable income by Philip and Kim (you are NOT required to calculate any possible tax payable). Your advice is to take the form of a report (adopting ILAC style) which will form part of the client work papers and should include a recommendation based on the known facts provided above as well as identifying any additional information that should be requested prior to providing any advice to the client.

Answer 1

Generally, capital gains tax (CGT) does not apply when one inherits an asset. However, it may apply later when one sells or otherwise disposes the asset. Unless the asset one inherits is fully exempt, one needs to know and note its market value at the date they died, and any related costs incurred by the legal personal representative. The total of this is the amount the asset is taken to have cost on the beneficially.

Phillip acquisition cost for inner Sydney 151 will be $370,000

The cost of renovation would be added to the acquisition cost that amounted to loan finance $100,000 + interest rate 5.5% = $105,500

Income Tax Assessment Act 1997 ("the 1997 Act")

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Co-owners who are not carrying on a business of letting rental properties must divide the income and expenses for the rental property in line with their legal interest in the property

Interest on money borrowed by only one of the co-owners, which is exclusively used to acquire that person's interest in the rental property, does not need to be divided between all of the co-owners.

Since Phillip and Kim bought the 153-155 temple street property jointly for residential purpose, they should share the all the costs even the loan interest expenses.

Even though they used the equity in the renovated property at 151 owned solely by Phillip.

For more information about dividing net rental income or losses between co-owners, see Taxation Ruling TR 93/32 - Income tax: rental property - division of net income or loss between co-owners.

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If property is let to relatives at less than commercial rent. The rent would represent assessable income. It would not necessarily follow, however, that losses and outgoings in relation to the property would be wholly deductible. The ultimate resolution of the matter would depend upon the purposes of the taxpayer in acquiring the property and in letting out to relatives.

The rent paid by a cousin should be submitted as a taxable income and will be treated as rental income. In addition, since Phillip and Kim rented out a 10% lower market value, the will be eligible for the 90% allowable deductions available for the 151 temple street property.

Taxation Ruling 2167 Income Tax: rental properties provides some guidance and examples on this, especially paragraphs 5-8 and 13-16.

The cost base of a CGT asset is largely what you paid for it, together with some other costs associated with acquiring, holding and disposing of it.

There are three methods for working out your capital gain. You can choose the method that gives you the best result - that is, the smallest capital gain.

CGT discount method

Eligible for assets held for 12 months or more before the relevant CGT event.

Allows you to reduce your capital gain by 50% for resident individuals

Formula

Subtract the cost base from the capital proceeds, deduct any capital losses, and then reduce by the relevant discount percentage.

Indexation method

Eligible for assets acquired before 11.45am (by legal time in the ACT) on 21 September 1999 or held for 12 months or more before the relevant CGT event.

Allows you to increase the cost base by applying an indexation factor based on the consumer price index (CPI) up to September 1999.

Formula

Apply the relevant indexation factor, and then subtract the indexed cost base from the capital proceeds.

Other method

Eligible for assets held for less than 12 months before the relevant CGT event.

It is the basic method of subtracting the cost base from the capital proceeds.

Formula

Subtract the cost base (or the amount specified by the relevant CGT event) from the capital proceeds.

Since Phillip and Kim are considering selling both 151 temple St. and 153-temple, St. both will be subject to CGT capital gain taxes. Because both properties fall under different categories, they will be taxed differently

151 Temple St

The day it was inherited will be considered as time acquired (March 2012) and considered selling on august 2019, time seven years and five months

Was acquired at $370,000

Expenses

Renovation $100,000

Interest $20,350

Agent indicates that the property could be sold at $1 million

Renovated 153 Temple St

Would use the CGT discounted formula as it was listed as primary resident.

The property was acquired on July 2017 and Phillip and Kim considered selling on august 2019, time two years

The property was acquired at $850,000

Expenses

Item	Amount
Legal	$40,000
Renovation	$100,000
Interest   (4.7% x 100,000 )	$4,700
Total	$144,700

The property was estimated to sell at 1.3 million