Main residence exemption - the effect of using your home to produce income

Capital gains tax implications of using your home to produce income while still living in it

Generally, you can ignore a capital gain or loss you make when you sell your main residence (also referred to as ‘your home’). This is known as the ‘main residence exemption’. However, you generally can’t obtain the full main residence exemption if you have used any part of your home to produce income.

This fact sheet explains the capital gains tax implications of using part of your home for income-producing purposes while continuing to live in it. It does not deal with where you move out of your home and then use all of it for income-producing purposes (for example, by renting it to tenants).

Are you entitled to a main residence exemption?

If you make a capital gain when you sell your home, you may not be entitled to the full main residence exemption (that is, part of the gain may be taxable) if you:

acquired the home on or after 20 September 1985
used part of the home to produce income at some time during the period you owned it, and
would be entitled to deduct interest had you incurred it on money borrowed to buy the home. This is known as the interest deductibility test.

When are you entitled to deduct interest?

If you run a business in part of your home, you are entitled to deduct part of the interest on money you borrowed to buy your home if:

part of your home is set aside exclusively as a place of business and is clearly identifiable as such, and
that part of the home is not readily adaptable for private use, for example, a doctor’s surgery located within a doctor's home.

If you rent out part of your home with access to general living areas on an arm’s length basis, you are entitled to deduct part of the interest on money borrowed to buy the home (see Taxation Ruling IT 2167).

In these situations you would satisfy the interest deductibility test. This means you would not obtain a full main residence exemption and so would have to pay tax on part of any capital gain made when you sell your home.

You may satisfy the interest deductibility test even if you didn’t borrow money to acquire your home – you must apply it on the assumption that you did borrow money to acquire it. You also satisfy the test if you were entitled to claim a deduction for the interest, even if you didn’t actually claim the deduction.

There is a special rule to work out the amount of your capital gain or loss if you first use your home to produce income in a way that satisfies the interest deductibility test after 20 August 1996.

When are you not entitled to deduct interest?

You are not entitled to deduct any of the interest on money borrowed to buy your home if, for convenience, you use a home study to undertake work usually done at your place of work. Similarly, you are not entitled to deduct interest if you do paid child-minding at home (unless you have set aside a special part of the home exclusively for that purpose).

In these situations you would not satisfy the interest deductibility test. This means you would obtain a full main residence exemption and so would not have to pay tax on any capital gain made when you sell your home.

How to work out your capital gain that is not exempt

The proportion of any capital gain or loss you take into account for tax purposes is an amount that is reasonable having regard to the extent that you would be entitled to a deduction for interest. In most cases this would reflect the proportion of the floor area of your home that is set aside to produce income and the period you use it for this purpose.

Example: Using part of a home for business for part of the period of ownership

Ruth bought her home under a contract that was settled on 1 January 1999. She sold it under a contract that was entered into on 1 November 2002 and settled on 31 December 2002. It was her main residence for the entire four years.

From the time she bought it until 31 December 2001, Ruth used part of the home to operate her photographic business. The rooms were modified for that purpose and were no longer suitable for private and domestic use. They represented 25% of the total floor area of the home.

When she sold the home, Ruth made a capital gain of $8,000. The following proportion of the gain is taxable:

Capital gain

X

percentage of floor area not used as main residence

X

percentage of period of ownership that that part of the home was not used as main residence

=

taxable proportion

$8,000

X

25%

X

75%

=

$1,500

As Ruth entered into the contract to acquire the home before 11.45am (by legal time in the ACT) on 21 September 1999 and entered into the contract to sell it after that time, and held it for at least 12 months, she can use either the indexation or discount method to calculate her capital gain. The indexation method doesn’t apply to assets acquired after 11.45 am on 21 September 1999.

The 'home first used to produce income' rule (explained below) does not apply because Ruth used the home to produce income from the date she purchased it.

Small business CGT concessions

If you are not entitled to a full main residence exemption because you use your home for business purposes, you may be able to apply the small business CGT concessions to reduce your capital gain. There are a range of CGT concessions for small businesses. In order to apply the concessions you need to satisfy certain basic conditions. The concessions will not be available if the main use of the premises is to derive rent.

For more information on the concessions, refer to Small business entity concessions essentials.

Where you first use your home to produce income after 20 August 1996

If you start using your home to produce income (in a way that would satisfy the interest deductibility test) for the first time after 20 August 1996, there is a special rule for working out your capital gain or loss.

In this case, you are taken to have acquired your home at its market value at the time it is first used to produce income if all of the following apply:

you acquired the home on or after 20 September 1985
you first used it to produce income after 20 August 1996
you would get only a part exemption because the home was used to produce assessable income during the period you owned it, and
you would have been entitled to a full exemption if you had sold the home immediately before you first used it to produce income.

The effect of this rule applying is that the period before the home is first used by you to produce income is not taken into account in working out the amount of any capital gain or loss. The extent of the exemption for the period after the home was first used to produce income depends on the proportion of the home used to produce income.

Example: Home first used to produce income after 20 August 1996

Louise purchased a home in December 1991 for $200,000. The home was her main residence. On 1 November 2001 she started to use 50% of the home for a consultancy business. At that time the market value of the house was $220,000.

She decided to sell the property in August 2002 for $250,000. The capital gain is 50% of the proceeds less the cost base.

Percentage of use

X

(proceeds – cost base)

=

capital gain

50%

X

($250,000 – $220,000)

=

$15,000

Louise is taken to have acquired the property on 1 November 2001 at a cost of $220,000. Because she is taken to have acquired it at this time, Louise is taken to have owned it for less than 12 months and therefore cannot apply the indexation or discount method to calculate her capital gain.

Need more information?

If you need more information about this fact sheet, you can:

speak to your tax adviser

visit the capital gains area of our website

phone 13 28 61, select option 3, then 3, and

you’ll also find more information the Guide to capital gains tax.

If you do not speak English well and need help from us, phone the Translating and Interpreting Service (TIS) on 13 14 50.

People with a hearing or speech impairment with access to TTY or modem equipment can phone 13 36 77.

People without TTY or modem equipment can phone the speech to speech relay service on 1300 555 727.

Last Modified: Tuesday, 6 October 2009

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