23 July 2023 – Column by Noel Whittaker
Australia is suffering a rent crisis because of insufficient rental accommodation, and at the same time many home-buyers are under mortgage stress because of continually rising interest rates. Could a win-win situation be created by householders with a mortgage renting out part of their home? It’s a realistic option – as long as you don’t get stuck with a tenant from hell – but how is the capital gains tax exemption for your residence affected if part of it is rented out?
Tax expert Julia Hartman of BanTacs has done the numbers, and tells me the scenario might not be too bad in the long term, but it is somewhat complex. Using your home to produce income will reset its cost base for CGT to its value on the date it became available to rent. From then on part of it may be subject to CGT.
Your home is worth $600,000, and you rent out a room for $200 a week. You calculate a fair proportion of the house used to produce the rent would be 25%, based on their share of the common living areas and their area of sole occupancy – just a bedroom. This should entitle you to a tax deduction for 25% of your interest, electricity, rates, ongoing maintenance and insurance. The rent is taxable income.
Five years pass and you stop taking boarders. During that time you earned $52,000 in rent, which really helped cover your mortgage, as you also had tax deductions of $43,750 over the period. If you keep the property for five more years and then sell it for $1 million, how much do you need to share with the tax man?
We start with the cost base of $600,000, set ten years ago. Then add all the costs of improving and holding the property that have not otherwise been claimed as a tax deduction. This would include interest, rates, insurance, repairs and maintenance after the property ceased being rented, and 75% of these while it was rented. The bad news is you’ll need to have kept good records; the good news is that, if you do, maintenance could even include cleaning materials, lawn mowing, etc.
For this exercise we will need to make some assumptions. Interest will be the biggest expense and it will reduce as the loan drops. However, let’s assume that total costs, including interest, averaged out to $35,000 a year.
In the five years the property was rented you would have claimed 25% of these costs in your annual tax returns, which means that the remaining 75% can be added to the cost base. That’s $26,250 a year. Then for the remaining five years you can claim $35,000 a year. This gives a cost base of $600,000 plus $306,250, or $906,250.
CGT is levied on the net sales proceeds, so if we assume a $1 million contract price, less selling costs of $30,000, the net proceeds are $970,000. That leaves a capital gain of $63,750. Apply the 50% CGT discount, and it’s only $31,875. But your main residence exemption protects most of the house from CGT – only 25% of the 5 years it was rented is taxable. That’s $3,984, of which you would only lose about a third in actual tax. In a $1 million transaction, $1,328 is hardly going to make a dint.
So, if you are prepared to commit to detailed record keeping for the rest of the time you own the property, the CGT impact is minimal.
Noel Whittaker is the author of Retirement Made Simple and numerous other books on personal finance. Email: email@example.com