Senate

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 5 - Principal residence exemption from CGT

Overview

5.1 Schedule 5 of the Bill will amend the Income Tax Assessment Act 1936 (the Act) to:

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extend the qualifying period for the capital gains tax (CGT) exemption on disposal of an inherited house from 12 months to 2 years;

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provide a partial CGT exemption for trustees and beneficiaries of deceased estates where the deceased never used the dwelling as a principal residence but beneficiaries of the deceased do so;

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treat a beneficiary or trustee who acquires a dwelling as a result of a death as having acquired the dwelling at its market value on the date of death if it was (or is deemed to be) wholly the principal residence of the deceased at the time of death; and

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require the use of market value as the cost base where a person's principal residence is first used for income producing purposes.

Summary of the amendments

Purpose of the amendments

5.2 The amendments contained in Schedule 5 of the Bill:

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extend from 12 months to 2 years the period in which a beneficiary or trustee of a deceased estate can dispose of the deceased's principal residence and still claim a full or part CGT exemption without the dwelling having been used as a principal residence after death [Division 1 of Part 1] ;

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provide a new partial CGT exemption to beneficiaries and trustees of deceased estates for the period that the dwelling was used as a principal residence after the death of the deceased where the deceased never used the dwelling as a principal residence [Division 2 of Part 1] ;

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provide a new CGT exemption to beneficiaries and trustees of deceased estates for the period before death where the dwelling was or was taken to be the deceased's principal residence at death and was not regarded as then being used for income producing purposes [Division 3 of Part 1] ; and

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provide a market value cost base at the first time a principal residence is used for income producing purposes [Division 4 of Part 1] .

Date of effect

5.3 The amendments will:

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extend the 12 month period to 2 years for disposals after 7.30 pm, 20 August 1996 (by legal time in the Australian Capital Territory) [item 34(1), Part 2] ;

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provide a new partial CGT exemption applying when a dwelling that was never used by the deceased as a principal residence is disposed of after 7.30 pm, 20 August 1996 (by legal time in the Australian Capital Territory) [item 34(1), Part 2] ;

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provide a new CGT exemption to beneficiaries and trustees of deceased estates for the pre-death period where the deceased's principal residence was acquired by the beneficiary or trustee after 7.30 pm, 20 August 1996 (by legal time in the Australian Capital Territory) [item 34(2), Part 2] ; and

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provide a market value cost base at the first time a principal residence is used by the taxpayer for income producing purposes after 7.30 pm, 20 August 1996 (by legal time in the Australian Capital Territory) [item 34(3), Part 2] .

Background to the principal residence exemption

5.4 Part IIIA of the Act brings to tax real gains realised on the disposal of certain assets acquired on or after 20 September 1985.

5.5 Section 160ZZQ of the Act, among other things, fully exempts from CGT a capital gain (or loss) on the disposal of a dwelling owned and used by a taxpayer as his or her principal residence (subsection 160ZZQ(12)).

5.6 Section 160ZZQ also:

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provides a partial exemption from capital gains (and losses) on the disposal of a dwelling owned and partly used by a taxpayer as his or her principal residence (subsection 160ZZQ(16)); and

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contains special provisions dealing with income producing principal residences (subsections 160ZZQ(11) and (21)) and inherited principal residences (subsections 160ZZQ(13), (13A), (14), (15), (17), (17A), (18), (19), (20) and (20C)).

Income producing principal residences

5.7 The principal residence exemption generally only applies to the extent that a dwelling was a taxpayer's principal residence (other than temporary absences - see subsections 160ZZQ(8) and (11)). The CGT provisions contain rules to apportion a capital gain or loss if the dwelling was partly used for income producing purposes (subsection 160ZZQ(21)).

Inherited principal residences

5.8 In most cases, death of a taxpayer will not attract CGT.

5.9 If, however, the deceased died on or after 20 September 1985 the dwelling will be taken to have been acquired by the beneficiary or legal personal representative at the time of death (see subsection 160X(5)). As a result, the beneficiary or legal personal representative may become liable to CGT if the dwelling is ultimately disposed of.

5.10 Broadly, if the dwelling was acquired by the deceased taxpayer before 20 September 1985, it will be taken to have been acquired by the beneficiary or legal personal representative at its market value at death (see paragraph 160X(5)(a)). If the dwelling was acquired by the deceased on or after 20 September 1985, the beneficiary or legal personal representative will be taken to have acquired the dwelling for its cost base, indexed cost base or reduced cost base (as appropriate) in the hand s of the deceased.

Full CGT exemption

5.11 Section 160ZZQ currently fully exempts a capital gain (or loss) on the disposal by a beneficiary or trustee of a deceased estate, of a dwelling that was the principal residence of the deceased person or was a pre-CGT dwelling if either:

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the dwelling is disposed of within 12 months of the deceased's death (subsections 160ZZQ(14) and (15)); or

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the dwelling is not disposed of within 12 months of the deceased's death but is used after the deceased's death as a principal residence by the beneficiary, another person entitled to do so under the deceased's will or the spouse of the deceased (subsections 160ZZQ(13), (13A) and (15)).

5.12 Unless the dwelling was acquired by the deceased person before 20 September 1985, a full exemption will usually only be available if the dwelling was the deceased person's principal residence for the entire time he or she owned it.

5.13 Subsection 160ZZQ(20C) also contains a full exemption in respect of a disposal of a principal residence by a trustee of a deceased estate where the dwelling was acquired by the trustee pursuant to the will of the deceased for occupation by another person and it is disposed of otherwise than to that person for no consideration.

Partial CGT exemption

5.14 A partial exemption from CGT is available if the deceased did not use the dwelling as his or her principal residence for the entire time he or she owned it. Similarly, a partial exemption is available if the dwelling is bequeathed to someone who does not use it as a principal residence and it is disposed of more than 12 months after the date of death. The partial exemption is available to the extent that the dwelling was a principal residence of the deceased, the beneficiary, another person entitled to occupy the dwelling under the deceased's will or the spouse of the deceased.

5.15 The partial exemptions are contained in subsections 160ZZQ(17), (17A), (18), (19), (20) and (20C).

Background to the amendments

The 12 month to 2 year extension

5.16 Beneficiaries and trustees of deceased estates may have difficulty arranging the orderly sale of the deceased's principal residence within the current 12 month period. These amendments will give beneficiaries and trustees more time to make appropriate arrangements by extending the current time limit by 12 months. [Division 1 of Part 1]

Deceased never used the dwelling as a principal residence

5.17 The partial exemptions in subsections 160ZZQ(17), (17A) and (19) currently do not apply if the deceased person did not use a post-CGT dwelling as a principal residence but after death the dwelling was used as a principal residence for the period until disposal. As a result, if the dwelling is passed to a beneficiary or trustee of the person's estate and is used as a principal residence by the beneficiary, another person entitled to do so under the deceased's will or the spouse of the deceased, that use as a principal residence will not attract any CGT exemption.

5.18 Any capital gain accruing during the period that the dwelling is used as a principal residence is subject to CGT. This CGT result is the same irrespective of whether the beneficiary or trustee sells the dwelling within or outside the (current) 12 month exemption period.

5.19 The proposed amendments will ensure that the use of the dwelling as principal residence will be recognised and will attract a partial exemption from CGT. [Division 2 of Part 1]

Market value at death

5.20 Section 160X of the Act currently requires the beneficiary or trustee of a deceased estate to calculate the relevant cost base for the purposes of the CGT provisions:

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if the dwelling is a pre-CGT asset, it will be taken to have been acquired for its market value at the time of death;

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if the dwelling is a post-CGT asset, it will be taken to have been acquired for the relevant cost base that would arise if the deceased had disposed of the dwelling immediately before death:

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when working out if a capital gain has accrued, the cost base or indexed cost base; or

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when working out if a capital loss has accrued, the reduced cost base.

5.21 This current law imposes two major compliance burdens on the beneficiary or trustee:

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the beneficiary or trustee must obtain records of the cost of acquiring the dwelling, of any improvements, and of incidental costs for expenses such as rates and interest, that were incurred over the time since the dwelling was acquired; and

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the beneficiary or trustee must be able work out the period that the dwelling was used as the principal residence of the deceased (and if necessary, previous owners, where the dwelling was inherited by the deceased).

5.22 The deceased may have kept no records because it would (in the case where the dwelling was the principal residence of the deceased) have been exempt if the deceased had disposed of the dwelling or the deceased may not have anticipated that the dwelling would cease to be their principal residence.

5.23 The amendments will alleviate these difficulties by removing the need to work out the relevant cost base of the dwelling. Trustees and beneficiaries who acquire a dwelling, which at the time of death was the deceased's principal residence and was not then used for income producing purposes, will be treated as having acquired it at its market value at the time of death. In addition, any periods prior to death where the dwelling was not used as a principal residence, or where it was used for income producing purposes will be ignored for the purposes of working out whether a CGT exemption applies and the extent of the exemption. [Division 3 of Part 1]

Market value at first income time

5.24 Where a tax payer starts using a principal residence (which is subject to a full CGT exemption) for income producing purposes, the taxpayer requires appropriate records of expenses that form part of the cost base of the dwelling so they can work out their CGT liability (if any).

5.25 Often the taxpayer would not have contemplated that the dwelling would be used for income producing purposes and would not have retained the necessary records. In particular, costs of improvements (such as extensions, pergolas and fencing) and other incidental costs (such as rates, land taxes and repairs) which also form part of the cost base may not be readily obtainable especially if the dwelling is disposed of some time after the expenses were incurred.

5.26 The amendments will remove the requirement to retain these records. Under the proposed new rules, taxpayers who first use their principal residence for income producing purposes will be required to calculate any CGT liability on the basis that they acquired the dwelling at the time it was first used for income production for a consideration equal to its market value at that time. [Division 4 of Part 1]

Explanation of the amendments

The 12 month to 2 year extension

5.27 If a trustee of a deceased estate or a beneficiary acquires (inherits) a deceased's principal residence, the trustee or beneficiary currently has 12 months to dispose of that dwelling without attracting CGT (see paragraph 160ZZQ(14)(b) and subparagraph 160ZZQ(15)(b)(i)).

5.28 In addition, a partial exemption is available where the dwelling is disposed of inside the current 12 month limit, but the dwelling was not used by the deceased for the whole period as a principal residence (see paragraphs 160ZZQ(18)(b) and (20)(b)).

5.29 The amendments will extend the time in which the dwelling must be disposed of from 12 months to 2 years. [Item 1]

5.30 The extension from 12 months to 2 years applies only to disposals after 7.30 pm, 20 August 1996 (by legal time in the Australian Capital Territory) [item 34(1)] . Disposals before this time are subject to the current 12 month period.

5.31 Because the amendment applies to disposals by trustees and beneficiaries after 20 August 1996, beneficiaries and trustees of deceased estates who acquired a principal residence after 7.30 pm, 20 August 1994 (by legal time in the Australian Capital Territory) may be able to take advantage of the new time limit.

Deceased never used the dwelling as a principal residence

5.32 This amendment will expand the available CGT principal residence exemptions by introducing a new partial exemption. [Items 2 to 14]

5.33 The new partial CGT exemption will apply to the disposal of a post-CGT dwelling by a beneficiary or trustee of a deceased estate where the deceased never used the dwelling as a principal residence but the beneficiary, another person entitled to do so under the deceased's will or the spouse of the deceased does. Under the current law, no exemption is available to recognise this use.

5.34 The new partial CGT exemption is only available for disposals after 7.30 pm, 20 August 1996 (by legal time in the Australian Capital Territory). [Item 34(1)]

5.35 The exemption is not necessary for disposals of pre-CGT dwellings as currently a full or part CGT exemption may apply to a beneficiary or trustee of a deceased estate who disposes of such a dwelling depending on the use made of the dwelling after death (see paragraph 160X(5)(a) and the inherited exemptions in subsections 160ZZQ(13), (13A), (17), (17A), (19), subparagraph 160ZZQ(15)(b)(ii) and paragraph 160ZZQ(20C)(b)).

5.36 The period that the dwelling is used as a principal residence is pro-rated over the period since the deceased acquired the dwelling (eg. the number of days the dwelling was used as a principal residence by the beneficiary divided by the number of days combined ownership of the deceased and the beneficiary).

5.37 Subject to special rules governing income producing use made of a principal residence, there are currently two general principles behind the principal residence exemptions set out in section 160ZZQ of the Act:

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use made of a dwelling as a principal residence by a living owner, a deceased owner, a beneficiary of a deceased estate, a person entitled to occupy the dwelling under the deceased's will or the spouse of the deceased (as appropriate) will be recognised for the purposes of working out whether a full or part CGT exemption applies. A full exemption will apply where this use spans the whole of the ownership period, otherwise only a part exemption will apply ("the pro-rata rule") .

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where an inherited principal residence is disposed of within 2 years of the death of the deceased, the period after death is ignored for the purposes of working out whether a full or part CGT exemption applies. A full exemption will apply where the deceased used the dwelling as a principal residence for the whole of their ownership period, otherwise a part exemption will apply if their use was for only part of the ownership period ( "the 2 year rule" ).

The pro-rata rule

5.38 Subsections 160ZZQ(12), (13), (13A) and subparagraphs 160ZZQ(15)(b)(ii) and (20C)(b)(i) provide full CGT exemptions for principal residence use covered by the pro-rata rule.

5.39 Subsections 160ZZQ(16), (17), (17A), (19) and subparagraph 160ZZQ(20C)(b)(ii) provide part CGT exemptions for principal residence use covered by the pro-rata rule.

The 2 year rule

5.40 Subsections 160ZZQ(14) and subparagraph 160ZZQ(15)(b)(i) provide full CGT exemptions under the 2 year rule.

5.41 Subsections 160ZZQ(18) and (20) provide part CGT exemptions under the 2 year rule.

5.42 Currently, there is some ambiguity concerning whether subsections 160ZZQ(17), (17A) and (19) reflect completely the pro-rata rule in circumstances where a dwel ling is inherited. The amendments remove this ambiguity. [Items 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13]

5.43 Subsection 160ZZQ(20A) provides that where a part exemption under the pro-rata rule and a part exemption under the 2 year rule both apply to a disposal of a dwelling, only that part exemption which deems the smaller capital gain or larger capital loss applies. The subsection is amended to recognise that the part exemption in subsection 160ZZQ(17) and the part exemption in subsection 160ZZQ(18) may now apply to the same disposal. [Items 2 and 14]

Market value at death

5.44 The amendments in items 15 to 30 will remove the need for beneficiaries and trustees to work out the cost base of the deceased person's principal residence for CGT purposes.

5.45 If a beneficiary or trustee of a deceased estate disposes of a post-CGT dwelling that was the deceased's principal residence at death and was not regarded (at time of death) as being used for income producing purposes, a new CGT exemption will apply for the period before death. The dwelling will be taken to have been acquired at death for its market value. [Items 15 to 30]

5.46 Any future capital gain or loss would be calculated by reference to this market value.

5.47 When working out if the deceased's principal residence will qualify for this new exemption, a dwelling will not be regarded as being used at death for income producing purposes where the dwelling was rented out for less than 6 years in accordance with subsection 160ZZQ(11). However a dwelling will be regarded as being used at death for income producing purposes where the dwelling is being lived in by the deceased and also being used for business purposes (eg. as a doctor's surgery) in accordance with subsection 160ZZQ(21).

5.48 The new exemption will only apply to principal residences that have passed to the beneficiary or trustee of the deceased estate after 7.30 pm, 20 August 1996 (by legal time in t he Australian Capital Territory). [Item 34(3)]

5.49 Under the current CGT exemption, the dwelling must have always been (or taken to have been) the deceased's principal residence during their ownership of the dwelling and must never have been regarded as being used for income producing purposes. Also the dwelling was taken to have been acquired at death for the indexed cost base in the hands of the deceased (rather than the market value of the dwelling at death).

5.50 The new CGT exemption is not necessary for acquisitions of pre-CGT dwellings as currently a full CGT exemption for the period before death (with a market value cost base at death) applies.

5.51 Depending on the use made of the dwelling after death, a full or part CGT exemption will apply in respect of the dwelling. A market valuation will not be necessary if a full CGT exemption applies.

5.52 The amendments also address an existing anomaly in section 160ZZQ of the Act. Under the current law, the period when a dwelling was the principal residence of the deceased is subject to capital gains tax if the dwelling was bequeathed to someone who does not use it as a principal residence and it is disposed of more than 12 months after the death of the deceased (the full CGT exemptions in subsections 160ZZQ(13), (13A) and (15) do not address this situation).

5.53 As a result of the amendments made by items 5, 6, 9 and 12 , this result will no longer arise. Subsections 160ZZQ(17), (17A) and (19) will now cover the situation where the deceased's principal residence was not used after death and disposed of more than 2 years after death. The effect will be that only the capital gain relating to the period after death will be subject to CGT. This approach is consistent with the underlying policy of only bringing to tax the component of a capital gain on a dwelling that relates to its non principal residence or income producing use.

5.54 The amendments remove the need for beneficiaries and trustees to work out the cost base of the deceased person's principal residence for CGT purposes by:

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inserting a new market value acquisition date at death into paragraph 160X(5)(a) of the Act [items 15, 16 and 17] ;

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providing that where the new market value acquisition date at death applies:

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any income producing use made of the dwelling in the period before death is ignored for the purposes of subsection 160ZZQ(21) but that where the new market value acquisition date at death does not apply, subsection 160ZZQ(21) applies at it applied before these amendments [new paragraph 160ZZQ(21)(f) - item 29, new subsection 160ZZQ(22) - item 30] ;

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any period that the dwelling was not used as a sole or principal residence before death is ignored for the purposes of the partial CGT exemptions in subsections 160ZZQ(17), (17A) and (19) [new subsection 160ZZQ(20AA) - items 20, 22, 25 and 27] ; and

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subsection 160ZZQ(20B), which allows the Commissioner to increase or reduce capital gains or losses (as appropriate) to take account of the use made of a dwelling before the deceased acquired the dwelling, does not apply [item 28] ; and

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replacing the condition in paragraphs 160ZZQ(13)(c), (13A)(c), (14)(c) and (15)(c) (full CGT exemptions) that the dwelling was during the deceased's ownership of the dwelling the sole or principal residence of the deceased, with a new less strict condition that the dwelling was immediately before the death of the deceased the sole or principal residence of the deceased. [Items 18, 19, 21, 23, 24 and 26]

Market value at first income time

5.55 When a taxpayer first uses a principal residence for income producing purposes in a way which immediately does or may detract from a full CGT exemption, the taxpayer will be taken to have acquired the dwelling at that time for its market value. [New paragraph 160ZZQ(20D)(f ) - item 33]

5.56 This new rule will apply when a taxpayer disposes of a post-CGT dwelling (whether the taxpayer purchased the dwelling or inherited the dwelling as a beneficiary or trustee of a deceased estate) that:

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was first used for income producing purposes by the taxpayer;

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that first use occurred after 7.30 pm, 20 August 1996 (by legal time in the Australian Capital Territory) [item 34(4)] ;

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a full CGT exemption would have applied if the taxpayer had disposed of the dwelling immediately before the taxpayer first used it for income producing purposes; and

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the eventual disposal is not covered by a full CGT exemption as set out in subsection 160ZZQ(14) or subparagraph 160ZZQ(15)(b)(i).

5.57 If this new rule applies, then the dwelling will be taken to have been acquired by the taxpayer at that first income time for its market value. The period before that time (including any time when a deceased person owned the dwelling) is to be disregarded. [New paragraph 160ZZQ(20D)(f) - item 33]

5.58 Any future capital gain or loss will be calculated by reference to this market value.

5.59 The market value cost base is not necessary for disposals of pre-CGT dwellings as currently a full CGT exemption for the period before disposal of the dwelling applies.

5.60 Depending on the nature and length of the income producing use, a full or part CGT exemption will apply in respect of the principal residence. For example if the income producing use is the rental of the principal residence for 2 years, then subsection 160ZZQ(11) may have the effect that a full CGT exemption is maintained. If the income producing use is a doctor's surgery on part of the principal residence, then subsection 160ZZQ(21) may have the effect that only a part CGT exemption applies.

5.61 If this new rule applies to a principal residence that has been inherited, the inherited exemptions in subsections 160ZZQ(13), (13A), (14), (15), (17), (17A), (18), (19), (20) and (20C) will be unavailable but instead the non-inherited exemptions set out in subsections 160ZZQ(12) and (16) will be available. This is because the taxpayer is deemed to have re-acquired the dwelling at the first income time other than as a beneficiary or trustee of the deceased's estate. [New paragraph 160ZZQ(20D)(g) - item 33]

5.62 Which of subsections 160ZZQ(12) and (16) will apply (if any), will depend on the use made of the dwelling after the first income time and the nature of the income producing use (ie. whether it falls within subsections 160ZZQ(11) or (21)).

5.63 The new rule does not apply to disposals covered by a full CGT exemption as set out in subsection 160ZZQ(14) or subparagraph 160ZZQ(15)(b)(i). [New paragraph 160ZZQ(20D)(e) - item 33]

5.64 Subsection 160ZZQ(14) and subparagraph (15)(b)(i) exempt any period that the dwelling was not a sole or principal residence of the taxpayer in the 12 month period (or 2 year period after these amendments are made) mentioned in those subsections whereas the new rule would subject this period to capital gains tax. The exclusion is necessary to ensure that this period remains exempt from CGT.

Consequential amendments

5.65 Paragraph (a) of subsection 160ZZQ(11) is amended to ensure that a reference to a dwelling ceasing to be the sole or principal residence of the taxpayer in subsection 160ZZQ(11) applies regardless of new subsection 160ZZQ(20D) deeming the taxpayer to have acquired the dwelling at the same time. [Item 31]

5.66 Subsection 160ZZQ(11) is amended to ensure that the subsection does not apply to new subsection 160ZZQ(20D) which deems the taxpayer to have acquired a dwelling at the first income producing use time, a time which may otherwise be disregarded by the effect of paragraph 160ZZQ(11)(g). [Item 32]