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The capital gains tax main residence exemption, affordable housing and caps

CGT beginnings

With wage and salary earners taxable on virtually every dollar they earn from their work, sources from the Asprey Report (1975) through to the tax summit of 1985 identified the lack of a capital gains tax as a tax regressive unfairness in the Australian income tax system which then relied on a narrower tax base. Before the CGT, gains on investments made by their owners escaped income tax and allowed already wealthier people to step up their wealth untaxed where less wealthy typically working people who paid their taxes could not.

Still it would have been near unthinkable for the Hawke Keating government of 1985 to have introduced the capital gains tax, which then was a partisan political and controversial proposal, into the Australian income tax system without CGT relief on the family home following the tax summit.

In those days a greater proportion of working people and middle Australia owned their own homes. So the exemption now legislated as the CGT main residence (MR) exemption in Division 118 of the Income Tax Assessment Act (ITAA) 1997, then not thought especially regressive, was a political price the government then had to pay to have a constituency-supported capital gains tax in the Australian income tax mix at all.

The uncontained housing tax exemption

But the breadth of the CGT MR exemption has made the CGT MR exemption itself regressive.

The CGT MR exemption is unlimited and especially generous when compared to CGT relief given in other countries.

The CGT MR exemption has these characteristics:

  • generally, where there is no income-earning use of a home and a taxpayer is or is taken to have occupied the home as their main residence while he or she has owned it, any capital gain on the home is fully exempted from the Australian CGT;
  • there is no qualifying length of ownership period to wait before the CGT MR exemption can be applied to exempt CGT on sale of an Australian home – the owner can live there for a month, rent the property out for five years, go overseas, come back and sell the (former) home and claim the full exemption – see section 118-145 of the ITAA 1997; and
  • a taxpayer can turnover any number of homes and keep claiming the exemption from CGT on every successive capital gain. In other words there are no limits on the amount of, or numbers of tax free step ups in, wealth a taxpayer can achieve with no taxation by selling each of their successive and possibly more expensive homes.

This has made Australian home ownership an incomparably attractive investment for tax reasons. This frustrates wider social housing objectives such as opportunity and ability for the populace to securely house themselves when they cannot afford to compete in the housing market especially as long term renting in Australia is not so secure either.

Sources of unaffordable housing

The CGT MR exemption has indisputably contributed to unaffordible housing both as a tax shelter, as a driver of demand for real estate and as an improver of the financial case to own an expensive home. To what extent is not for a tax lawyer, who is no econometrician, to judge. The CGT MR exemption may not even be the greatest contributor to unaffordable housing in Australia. Housing markets around the world are elevated due to the abundance of money injected into major economies by quantitative easing. But in Australia add:

  • dark money laundered through Australian real estate attributable to persisting slack regulation of money flows into Australia, including continuing failure by government to commence the 2007 AML/CTF measures to expand the range of oversight of AUSTRAC to non-financial businesses and professions including the legal, accounting and real estate professions: see my 2017 blog – Sluggish anti-money laundering reform in Australia https://wp.me/p6T4vg-6J and The Lucky Laundry by Nathan Lynch https://cutt.ly/JCwVAyK;
  • housing financialisation; and
  • light and regressive taxation of housing in Australia;

to the reasons why Australian residential property prices have reached the unaffordable levels they have.

The wrong culprit

Light taxation has been widely canvassed in the media as a contributor to unaffordable housing but journalists and commentators frequently focus on the 50% CGT discount for investors and negative gearing as the tax system causes of unaffordable housing unfortunately ignoring the CGT MR exemption or even the various land tax exemptions that Australian state and territory governments extend which shelter owner-occupied homes from state taxation too.

The 50% CGT discount was an inexplicable 1999 adjustment to sound original design of the CGT in 1986. It replaced the indexation of cost (base) which was to ensure an investor paid tax only on a real capital gain after adjusting for inflation but at ordinary income tax rates so the CGT could work fairly and progressively as designed. The 50% CGT discount instead effectively and regressively reduced the income tax rate on investment capital gains made by property investors, as it turned out, during a period of negligible inflation which the 50% discount was meant to overtly but more crudely counter. Now inflation is back so a nuanced policy response may be to scrap the 50% CGT discount and to revert back to the 1986 indexation of cost which should never have been altered in the first place.

In contrast to the CGT MR exemption, the 50% CGT discount has a waiting period, 12 months – see section 115-25 of the ITAA 1997, which is not much, and is limited to 50% as a highest discount to individuals. Like the CGT MR exemption, availability is not limited or capped to those who qualify and this is a boon to investors in the property market although major investors and developers need to be tax wary that their property investment activity is not treated by the Commissioner of Taxation as a business of profit-making by sale with the consequences that:

  • proceeds of sale of investment in housing become taxable as ordinary income;
  • thus CGT relief, such as the 50% CGT discount, is unavailable – see section 118-20 of the Income Tax Assessment Act (ITAA) 1997; and
  • their activities become an enterprise where they must charge the goods and services tax (GST) to buyers for reasons set out in Miscellaneous Taxation Ruling MT 2006/1.

Tax relief saving for a home?

The CGT MR exemption is of no benefit to someone who is saving for a home, but does not have a home yet, whom one would think would be the focus of a real and progressive tax exemption to house. Capital gains made on investments by someone saving for a home are not exempt from tax, and get no better than the 50% CGT discount I have maligned in this post, which is odd when it is understood the tax system gives already housed wealthier citizens, who may turnover a series of homes of increasing value and for increasing gains, full tax relief on each gain made on their homes through the CGT MR exemption.

For the CGT MR exemption to be fairer, and to discourage home buyers from taking on higher mortgages to get into the housing market where ruin may be more likely than gain, could the CGT MR exemption extend to capital gains made by persons who are saving for a home or who are yet to own home on portfolio assets set aside to buy a home they hold in the interim? Clearly the former First Home Saver’s Account scheme, which was an utter failure and repealed in 2014, was not ambitious enough and was a false move to help those accumulating what they need to buy a home.

A cap on the CGT main residence exemption?

A limit or cap could be put on the CGT MR exemption that a taxpayer can use to exempt capital gains on his or her home during their lifetime. This would take heat out of the housing market.

An arguably generous lifetime cap of $A 1 million would still bring in substantial additional CGT revenue that could fund social and universal housing and reduce the CGT MR exemption rort by those who take large or multiple full exemptions on their turnover of increasingly expensive homes. The CGT system already uses a lifetime limit in the small business CGT retirement exemption rules in Subdivision 152-D of the ITAA 1997 and caps now limit contributions that can be put into tax concessional superannuation on tax fairness and equity grounds.

A home turnover limitation?

In many countries in Europe a holding period of less than five years can cause capital gains on assets including the family home to be taxable. Tax relief cuts in where an asset is held for longer. Are their approaches something Australia should also consider when looking at tax exemptions and concessions for housing?

Challenge

There is no doubt changes that really improve Australian housing affordability and address inequitable and fiscally disastrous untethered tax exemptions will be politically fraught especially when there are so many interests vested in the present tax system who may lose with change. In the bigger picture lightly taxed property gains and unquarantined negative gearing deductions can be seen as scourges when proper taxation, orthodox monetary policy and extended oversight of criminal money flows could be used to re-balance the housing investment market with the social housing needs of Australia’s citizens.

Keeping the CGT main residence exemption when working from home

home

Only a partial exemption from capital gains tax (CGT) is available to the extent a main residence is used for an income-producing use: section 118-190 of the Income Tax Assessment Act (ITAA) 1997.

As the CGT main residence exemption is, or can be, so valuable – there is often no bigger tax break to an individual in their lifetime; an individual working in their business or their employment from a home they own will be looking to preserve the full CGT main residence exemption (MRE) where they can.

Setting the scene

For most taxpayers opportunity to claim the full CGT MRE will be straight forward. The Australian Taxation Office (ATO) website

Home-based business and CGT implications | Australian Taxation Office https://cutt.ly/ZDOjOWt

re-assures a home owner simply working from home from a desk, chair and a computer that a full CGT MRE will be available where the ATO states:

Generally, when you sell your home CGT doesn’t apply. However, if you used any part of your home for business purposes, you may have to pay CGT. CGT won’t apply if any of the following occurred with your home-based business:

– You operated your business from a rented home.

– You didn’t have an area specifically set aside for your business activities.

– You operated your business through a company or trust.

You only have to pay CGT for periods when you used your home for your business.

Home-based business and CGT implications | Australian Taxation Office https://cutt.ly/ZDOjOWt

But the ATO’s page isn’t the whole story. The ATO’s first dot point is so obvious that it shouldn’t be in the list but is helpful to any renters that may happen on to this page of course. The ATO’s second dot point is reassuring especially as all that is physically needed by many workers working from home is that chair, desk and computer. This derives from the distinction between homes with a place of business and those not with a place of business and how they are treated for the CGT MRE considered later in this blog. The third dot point is partly right. What about, though, where a related company or trust, which is a separate entity to an individual owning his or her home:

  • pays rent to the owner for the use of the home?; or
  • meets or helps meet the expenses of the owner of the home?

Separate entity – related company or trust

Let’s say Fred owns his own home and Fred has a related company from which Fred conducts his business from home. If the company rents a room in the home then the CGT MRE is reduced to a partial CGT exemption when Fred sells his home as:

  • Fred has earned rental income from the company, a separate legal entity; and
  • Fred will either have deducted, or could have deducted, interest on money borrowed put to the home, if any – see paragraph 118-190(1)(c) and sub-section 118-190(2);

as section 118-190 then applies.

Don’t charge rent

If Fred is the sole owner of his company then an obvious first measure of tax planning to ensure Fred keeps the full CGT MRE is for Fred not to charge rent to the company.

But where Fred charges no rent to the company this has implications for expenses like heating and cooling and other expenses Fred incurs, and has no rent to cover, when the company occupies his home for no charge and carries on its business from there remembering:

  • Fred is not entitled to deduction for the expenses of his company which is a separate entity to him and which are essentially private to him; and
  • the company is not entitled to a deduction for expenses for which Fred, rather than the company, is responsible even where the company pays those expenses (without considering fringe benefits tax implications where Fred is also an employee of the company as well as a shareholder).

Can the company instead reimburse Fred, sustain deductions for the expenses of the home it meets as business expenses and not disturb the CGT MRE position of Fred?

Legalities – a licence!

Firstly the company is, as stated, a separate legal entity to Fred. To clarify its basis for using Fred’s home, the company and Fred should document what the company can do at his home.

Secondly a document between Fred and the company under which the company can enter and use Fred’s home to run its business without paying rent to Fred is likely not a lease. It is a licence to enter the home granted by Fred and to do the things at the home which Fred allows the company to do under the licence.

Thirdly the licence terms can specify and delimit the home expenses of Fred which the company will reimburse to Fred.

Running expenses vs. occupancy expenses

The Commissioner of Taxation’s Taxation Ruling TR 93/30 Income tax: deductions for home office expenses explains two significant dichotomies:

Firstly TR 93/30 distinguishes between running expenses, being the costs of living at a home, and occupancy expenses which are the costs of owning a home. These examples are given:

Occupancy expenses –  relating to ownership or use of a home which are not affected by the taxpayer’s income earning activities (i.e., occupancy expenses). These include rent, mortgage interest, municipal and water rates, land taxes and house insurance premiums.

Running expenses – relating to the use of facilities within the home. These include electricity charges for heating/cooling, lighting, cleaning costs, depreciation, leasing charges and the cost of repairs on items of furniture and furnishings in the office.

Paragraph 6 of TR 93/30

Secondly, from the tax cases on the issue, TR 93/30 draws a distinction between an area of a home to be treated as a place of business and an area of a home which is not to be so treated. This ties back to the ATO observation in the second dot point on Home-based business and CGT implications about a part of a home specifically set aside for business activities.

Safe harbour for a full CGT MRE

To my mind a CGT MRE safe harbour for Fred would be for the licence:

  • to allow Fred reimbursement by the company for running expenses related to the use of the home by the company for business purposes; and
  • to preclude reimbursement by the company for occupancy expenses;

to Fred. Then the ATO would have no reason to treat payments by the company to Fred or payments by the company to meet expenses of the home on Fred’s behalf as either rent or as contributions to Fred’s occupancy expenses so that the CGT MRE of Fred then diminishes to a partial exemption where these payments do not exceed the applicable running expenses that Fred can recover under the licence.

On the other hand a reimbursement of occupancy expenses to Fred is an indicator to the ATO that Fred is allowing a physical part of the home itself, whether or not that part is a place of business or not based on the indicators of a place of business described in TR 93/30 (see below), to be used by the company in its business to earn income and a notional apportionment between use as a main residence and income earning leading to a diminished partial CGT MRE under section 118-195 might then follow.

Sole trader or partnership

Where the owner of the home is a sole trader, or where the owners of the home are carrying on a business in partnership, then the issue of licence to enter and use the home and reimbursement of home expenses to owners as separate entities won’t arise.

In those cases closely abiding by TR 93/30 can give home owners working from home safe harbour from a partial CGT MRE so long as:

1. the home has no place of business viz like:

the area is clearly identifiable as a place of business;

the area is not readily suitable or adaptable for use for private or domestic purposes in association with the home generally;

the area is used exclusively or almost exclusively for carrying on a business; or

the area is used regularly for visits of clients or customers.

from paragraph 5 of TR 93/30. A home-based doctor’s surgery is given as an example of a place of business in paragraph 4 of TR 93/30.

2. tax deduction claims by the sole trader or partnership are constrained to running expenses and occupancy expenses are excluded from those tax deduction claims.

Unpacking taxes on foreign persons – the Australian vacancy fee

VisaArrived
Clip Royalty Free Stock Country Passport Stamps Clipart – Australia @seekpng.com

Laws reflect perspective. When the imposition of laws, especially taxes, turns on whether the taxpayer is a local (resident) or foreign (non-resident) then laws will be designed with elusion in mind so someone cannot elude being treated as:

  • local if the burden and focus of the law (such as a tax) falls on locals; and
  • foreign if the burden and focus of the law falls on foreigners.

Income tax – focus on locals

The Income Tax Assessment Act (C’th) (ITAA) 1936 overall might be considered to be in the former case in Australia. Although Australian non-resident income tax rates can be higher than resident rates, generally a wider range of activity of residents is taxable in Australia, and residents are subject to income tax on their worldwide income. Income tax collection under the ITAA 1936 and 1997 is mainly focussed on collecting income tax from residents. Certainly Australian locals can be income taxed with fewer international constraints.

Thus who is a “resident” or “resident of Australia” in the definition of these terms in sub-section 6(1) of the ITAA 1936  includes, among others: an Australian citizen whose domicile, by virtue of that citizenship, is in Australia unless the Commissioner of Taxation is satisfied the person’s permanent place of abode is outside of Australia. This definition part imposes a satisfaction hurdle without which an Australian citizen, with a domicile in Australia, will be an income tax resident with broad exposure to income tax under the ITAA 1936 and 1997.

Foreign acquisitions and takeovers – focus on foreigners

In contrast the burdens imposed by the Foreign Acquisitions and Takeovers Act (C’th) 1975 (FATA) in Australia are on foreigners and is so, along with the state and territory foreign person surcharges mentioned below, an example of the latter case in Australia. The FATA is concerned with the acquisition, monitoring and control of Australian real estate and other Australian-based investment interests by foreigners. The FATA obliges notification to the Foreign Investment Review Board (FIRB) of proposed acquisitions of specified types which can be approved or rejected by the Australian Treasurer on the recommendation of the FIRB.

Vacancy fee

A vacancy tax on foreigners commenced under the FATA as a measure to improve housing affordability for Australian locals in 2017. The vacancy fee is contained in Part 6A of the FATA under which a foreign person who owns a residential dwelling in Australia is charged an annual vacancy fee where the dwelling is not residentially occupied or rented out for more than 183 days in yearly periods which measure from the date of acquisition of ownership by the foreigner. The vacancy fee under Part 6A is imposed as a tax by section 5 of the Foreign Acquisitions and Takeovers Fees Imposition Act (C’th) 2015.

Vacancy fee rates

Vacancy fee rates are tethered to the FIRB fees (also imposed as taxes under the same section 5) applicable to a foreign person making an application to acquire the residential land. which is ad valorem based on the value of the real estate on acquisition. Here is an extract from a table with the ad valorem fees:

Acquiring an interest in residential land where the
price of the acquisition is…		Fee payable
less than $75,000$2,000
between $75,000 – $1,000,000$6,350
between $1,000,001 – $2,000,000$12,700
between $2,000,001 – $3,000,000$25,400
from FIRB Guidance 10 Fees on Foreign Investment Applications (18 Dec 2020)

Under section 4 of the FATA:

“foreign person” means:
(a) an individual not ordinarily resident in Australia; or
(b) a corporation in which an individual not ordinarily resident in Australia, a foreign corporation or a foreign government holds a substantial interest; or
(c) a corporation in which 2 or more persons, each of whom is an individual not ordinarily resident in Australia, a foreign corporation or a foreign government, hold an aggregate substantial interest; or
(d) the trustee of a trust in which an individual not ordinarily resident in Australia, a foreign corporation or a foreign government holds a substantial interest; or
(e) the trustee of a trust in which 2 or more persons, each of whom is an individual not ordinarily resident in Australia, a foreign corporation or a foreign government, hold an aggregate substantial interest; or
(f) a foreign government; or
(g) any other person, or any other person that meets the conditions, prescribed by the regulations.

section 4 of the FATA

It follows that any person, including an Australian citizen, can be a foreign person caught by these provisions however, under a convoluted exemption arrangement, Australian citizens who are not ordinarily resident in Australia are relieved from the vacancy fee.

Relief for non-resident Australian citizens

I understand that the relief works in this way:

Section 28 of the Foreign Acquisitions and Takeovers Regulation 2015 [Select Legislative Instrument No. 217, 2015] (FATR 2015) prescribes every section of the FATA, aside from the definition of foreign person in section 4 itself and other provisions to which that definition relates to, as excluded provisions. (Bold emphasis added by me.)

Section 28 also carries a note which provides:

The effect of this Division is that acquisitions of interests of a kind mentioned in this Division are not significant actions, notifiable actions or notifiable national security actions, but are taken into account for the purposes of the definition of foreign person in section 4 of the Act.

Note to section 28 of the FTAR 2015

and

paragraph 35(1)(a) of FATR 2015 provides:

Acquisitions of any land by persons with a close connection to Australia

(1)  The excluded provisions do not apply in relation to an acquisition of an interest in Australian land by any of the following persons:

(a)  an Australian citizen not ordinarily resident in Australia;

…

paragraph 35(1)(a) of FATR 2015

There does not appear to be any further “close connection”, as referred to in the heading to section 35, required to trigger the exemption beyond being an Australian citizen in the case of paragraph 35(1)(a). That is: a non-resident Australian citizen has, by virtue of being a citizen, a close connection to Australia.

Application of the non-resident Australian citizen exemption to the vacancy fee?

The vacancy fee, though, is a tax imposed on a foreign person when a dwelling, already acquired by the foreign person, is not residentially occupied or rented out for more than 183 days in yearly period as stated above. Could it be that a foreign person, including a non-resident Australian citizen, will still be caught by the vacancy fee because the vacancy fee is concerned with omission to occupy or rent out property for more than 183 days over a yearly period and not with acquisition of the property so paragraph 35(1)(a) relief can’t be attracted?

The answer appears to be in section 115B of the FATA which scopes when vacancy fee liability under Part 6A arises. Section 115B provides:

Scope of this Division–persons and land
(1) This Division applies in relation to a person if:
(a) the person is a foreign person; and
(b) the person acquires an interest in residential land on which one or more dwellings are, or are to be, situated; and
(c) either:
(i) the acquisition is a notifiable action; or
(ii) the acquisition would be a notifiable action were it not for section 49 (actions that are not notifiable actions–exemption certificates).
Note: Regulations made for the purposes of section 37 may provide for circumstances in which this Division does not apply in relation to a person or a dwelling….

sub-section 115B(1) of the FATA

It follows that the provisions of “this Division”, which is Division 2 of Part 6A of the FATA and which contains the provision imposing vacancy fee liability, are excluded provisions and so vacancy fee liability on an omission to occupy or rent residential land, where the interest in that residential land was acquired by a non-resident Australian citizen under paragraph 35(1)(a) of FATR 2015, is not attracted by a non-resident Australian citizen purchaser of the residential land. That is so even though a non-resident Australian citizen is a foreign person caught by paragraph 115B(1)(a).

This is a very complicated way to exempt non-resident Australian citizens from treatment as foreigners. Couldn’t section 4 of the FATA just carve out non-resident Australian citizens from being foreign persons to broadly the same effect?

Adding to the confusion is FIRB Guidance Note 31 Who is a foreign person (1 July 2017) which refers to paragraph 15 of the decision in Wright v. Pearce (2007) 157 CLR 485 as guidance on the position with Australian citizens. This reference is actually in error and should be Wight v. Pearce (2007) 157 FLR 485 (not a decision of the High Court of Australia). In any case I can’t see where that reference has anything to say about resident and non-resident Australian citizens having a close connection to Australia, which, unlike being ordinarily resident in Australia which is the matter under consideration at paragraph 15 of the case, is the apparent touchstone of liability when paragraph 35(1)(a) of FATR 2015 is taken into account.

Comparison of the federal vacancy fee with state foreign person surcharge land tax and surcharge purchaser duty

The vacancy fee can apply over and above the foreign person surcharge land tax and surcharge purchaser duty imposed by Australian states introduced at around the same time also to achieve housing affordability for Australian locals.

The foreign person surcharges in New South Wales also adopt the “foreign person” formulation in section 4 of the FATA to pinpoint foreigners liable to the surcharges but with modifications including under paragraph 104J(2)(a) of the Duties Act (NSW) 1997:

(a) an Australian citizen is taken to be ordinarily resident in Australia, whether or not the person is ordinarily resident in Australia under that definition,

paragraph 104J(2)(a) of the Duties Act (NSW) 1997

which carves out non-resident Australian citizens from “foreign persons” and thus the complexity of excluded provisions from the FATR 2015, a Commonwealth statutory instrument, do not need to be contended with to find exemption for non-resident Australian citizens from the surcharges.

In making a comparison between the the federal vacancy fee on the one hand with state foreign person surcharge land tax on the other hand it should also be observed that the state foreign person land tax surcharges are generally imposed on foreigners per se, that is: whether the residential land is vacant for a period is immaterial. So omission by a foreign person to occupy or rent out property for more than 183 days generally means liability for both the federal vacancy fee and a state land tax surcharge will be attracted.

Temporary residents

When an individual owner of residential real estate is not an Australian citizen then whether the individual is ordinarily resident in Australia does become a touchstone for tax and surcharge liability as a “foreign person”. Sub-section 5(1) of the FATA provides:

(1)  An individual who is not an Australian citizen is ordinarily resident in Australia at a particular time if and only if:

(a) the individual has actually been in Australia during 200 or more days in the period of 12 months immediately preceding that time; and

(b)  at that time:

  (i)  the individual is in Australia and the individual’s continued presence in Australia is not subject to any limitation as to time imposed by law; or

  (ii)  the individual is not in Australia but, immediately before the individual’s most recent departure from Australia, the individual’s continued presence in Australia was not subject to any limitation as to time imposed by law.

Sub-section 5(1) of the FATA

A temporary resident for tax is someone who is not an Australian citizen or permanent resident who can stay in Australia under an immigration visa which, as a matter of course, will be a visa with a limitation as to the time the holder can stay in Australia.

A temporary resident is taxable for income tax only:

  • on income derived in Australia; and
  • on foreign income but only foreign income earned from employment or services performed overseas while a temporary resident.

A temporary resident is not income taxable on capital gains made on assets which are not Taxable Australian Property e.g. real estate.

See the ATO website here: https://is.gd/DbJJmk

A temporary resident is a foreign person under the FATA no matter how long the individual is present in Australia until and unless the temporary resident becomes a permanent resident or an Australian citizen due to paragraph 5(1)(b) of the FATA as set out above.

Temporary residents can acquire residential real estate, including established residential premises with conditions, under the FATA and FIRB regime however the vacancy fee and the state and territory foreign person surcharges can apply to their interests in Australian residential land.

Permanent residents

As permanent resident visa holders are not subject to any limitation as to time they can be in Australia imposed by law the requirements in paragraph 5(1)(a) of the FATA are of ongoing concern to them until and unless they become Australian citizens. That is: a permanent resident who has not actually been in Australian for 200 days in the applicable preceding twelve months is taken not to be ordinarily resident in Australia despite their visa.

If such a permanent resident owns Australian real estate but has not been in Australia for the required 200 days in an applicable twelve months then he or she is a foreign person for that year. Then the vacancy fee and the state and territory foreign person surcharges can apply to a permanent resident’s interests in Australian residential land.