AUSTRALIAN TAX LAW

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AUSTRALIAN TAX LAW

The main driving force for investment is the ability to generate revenues and maximize returns. Profits are a good metric for determining the long-term viability of a project. When it comes to property investments, the returns are measured in terms of capital gains and rental yields¹. Rental yields refer to incomes that are generated by an investment property. On the other hand, capital gains refer to profits generated from the sale of an asset. Before 1985, Australia did not have a proper tax on capital gain and this saw numerous capital gains transactions get excluded from the income cost base². The capital gains tax was legislated in 1985 and applied to all realized gains or losses that occurred post 19 September 1985³.

An asset’s cost base is determined per section 160ZH governing capital gains tax law. In general, the provision states that expenditures incurred by the taxpayer in connection with the acquisition of an asset, as well as capital costs of keeping and maintaining the taxpayer’s interests in that asset, are included in the asset’s cost base. To assess the cost basis of a taxpayer’s asset, a taxpayer may be regarded to have incurred expenditure in certain circumstances. The cost base is indexed to calculate a capital gain if the asset is held for at least twelve months before being sold by the taxpayer⁴.

Acquisition of Residential Property

Louisa, an Australian resident is subject to the post-1999 law governing taxation on capital goods and also those governing rental properties. Louisa purchased a rental property on 1^st December 2015 paying $200,000 in cash while the rest was paid upon purchase of a rental property. In addition, she borrowed 750,000 from a local bank which was to be repaid in 25 years. For purpose of recording capital gains, the interest charged on funds used to acquire a non-residential house such as real estate or rental property is subject to be included in the ownership cost calculations and added to the taxable base. The interest on the mortgage will be computed on a simple interest basis and recorded in the ownership cost section. Based on the Australian Law on CGT post-1999 assets are subject to include the mortgage interest expenses when determining the total cost base⁵.

Mortgage total costs= P(1+r*t)

Interest costs= P*r*t

Where P=Principal amount

r- rate

t- time

T. Interest cost= 750,000*4%*25 years

= 750,000

Based on the above computations, Louisa was entitled to record 750,000 in the total ownership costs which will later form part of the cost base. In addition, Louisa should also record 750,000 which is the principal amount she borrowed for the purchase of the property and which she will be entitled to pay back to the commercial bank.

Initial Purchase Costs

Louisa has a fundamental duty to identify and record all costs incurred during the initial purchase of the goods. This is per the 1999 CGT legislation⁶, an individual has a duty to the following; First, an individual should correctly identify the data upon which the purchase of the Capital asset was made and record it accurately. Secondly, an individual has to record every transaction that contributes to the functioning of the asset regardless of whether it amounts to a capital gain or capital loss⁷. Purchase costs play a crucial role in determining the total cost base which is then offset from the selling price to determine whether there was a capital gain or loss. Based on the above transaction; Louisa should identify and record the following purchase costs;

• Stamp duty: $26,000

• Legal fees: $2,000

• Mortgage broker commission: $1,200

• Mortgage fee application: $500

The above transactions occurred in 2016 and thus Louisa is bound by the 1999 CGT regulation on capital assets⁸. Based on the regulation, all initial costs of purchase including, stamp duties, legal fees, and other costs incurred to enable the purchase of the property are subject to inclusion in the total purchase costs and offset against the sales cost as per the CGT criterion.

Residential Income Tax

Residential rental income is the total compensation a landlord receives from a tenant for leasing out an immovable property. Rental income is classified as ordinary income and not offset against the cost base in assessing whether there is a capital gain or loss. As Louisa acquired the building there were already existing residents and who continued residing in the place until 1^st July 2018. The tenants paid a weekly fee of $800. The rental income is not included in the capital gains tax but rather included in the rental income ta as per the Australian Law governing Taxation.

Ownership Costs

1. Recarpeting Costs and Depreciation

Based on a recent law passed on 1^st July 2017 governing the transactions subject to depreciating residential rental properties, individuals are entitled to claim depreciation on an assets purchase price if⁹;

• The assets purchased are brand new and

• If the assets purchased were newly built and nobody had previously claimed depreciations.

Louisa having incurred the expense of 17,000 on 1^st July 2018 to generate rental income is subsequently entitled to claiming depreciation upon sale of the property. However, Louisa cannot claim depreciation for the building since it was acquired second-hand through a transfer of ownership. The depreciation amount can however not be included in the capital gains deductions as per the CGT regulations in Australian law. The depreciation for the carpet is computed using a reducing balance method with a scrap value of 0 and an expected useful life of 10 years beginning 3^rd Jul 2018.

In an attempt to improve the residential premises Louisa incurs a cost of 17000 in recarpeting. The recarpeting cost will therefore be included in the cost base of the property and subsequently offset against the total price she sells the property. Having completed the recarpeting process, Louisa embarks on an advertising journey to find new tenants. According to the post, 1999 law governing advertising costs form part of the cost base costs and are included in the ownership costs and used to determine whether there arises a capital gain or a capital loss¹⁰. Therefore, the advertising cost of $1500 to find a new tenant will be included in the ownership costs and used to determine whether there was a capital gain or loss.

2. In-ground Swimming pool Construction and Advertising Costs

Louisa fails to find tenants and therefore goes further to construct an in-ground swimming pool at $24000 on 1^st September 2018. The cost is incurred in an attempt to distinguish the residential premises and attract tenants. According to the CGT legislation enacted in 1999¹¹, all costs incurred in an attempt to improve a property must be included in the cost base of an asset. Therefore, Louisa will include the swimming pool construction cost of $24000 in the ownership costs which will be finally offset against the price at which the property is sold. In addition, Louisa incurs an advertising cost of $500. Advertising costs to find new tenants are included in the calculation of the cost base and thus included in determining whether there was a capital gain. This is per the 1999 CGT law governing transactions that are included in the capital gains computation criteria¹².

Treatment of Rental Income

Having incurred several costs to improve the residential property, Louisa is successful in finding a tenant who moves in on 15^th September 2018. The new tenant is subject to pay rental charges of 900 per week. Rental income is categorized as ordinary income and thus not included in the capital gains tax computations. However, the Australian law governing taxation requires Louisa to pay rental income taxes per financial year¹³.

Damages and Legal fees

On 1^st January 2020, a tenant fell off the stairs and plans to sue Louisa. The damage costs and the legal fee expense are among the ownership costs Louisa has to bear after the accident occurred. Though she believes that she was not at fault, professional legal advice plays a key role in influencing her decision. The damage costs will be treated under the 1985 regulation pertaining treatment of CGT. Based on an underlying asset approach as the case between Provan and Rolfe¹⁴, it is crucial to include all legal costs and compensations incurred to supplement the disposal proceeds. However, a case between Namol Pty Ltd v. AW Balderstone Pty Ltd displayed a contrary opinion towards including damages since it would unnecessarily lead to an increase in the tax liability. However, based on a further enactment of the 1999 law governing CGT, it is crucial to include the cost of damages in the cost base calculations¹⁵. Further costs such as legal costs are considered as owners’ costs and thus included in the calculation of the cost base. The costs incurred to settle the dispute were necessary for preventing further escalation of the matter which would have further pushed the costs of ownership higher.

Capital gains upon sale of Property

Louisa decides to sell the property for 1,700,000 but a willing buyer offers 1,580,000 on 15^th July 2020. Based on Provan’s case the plaintiff was granted additional considerations following the disposal of a property below the market value. In this case, the real estate agent also believes that Louisa could fetch a higher CST for the property. This leaves room for future considerations to incase Louisa displays discontent. However, in this case, and following the CGT law, Louisa will record the actual price at which she disposes of the asset of 1580000. This price received will be used to offset the total cost base to determine whether there was a capital gain or capital loss.

Disposal costs

According to the CGT 1999, it is crucial to record all associated costs upon disposal of an asset¹⁶. These costs include; advertising costs, legal fees, real estate commission, and mortgage discharge fees. Louisa must therefore include the costs incurred at disposal in the cost base and offset that against the sales value to determine the capital gain or loss. Louisa will therefore include the following costs;

• Advertising: $2,800

• Real estate commission: $35,000

• Legal fees: $2,000

• Mortgage discharge fee: $800

Discounting Capital Gains

Based on the law post 20^th August 1996, rental properties held for over 12 months are subject to a 50% discount. Therefore, Louisa once determining she has a capital gain will only pay capital gains tax for 50% of her total profits.

The capital gain or loss from the sale of the property

Figure 1

Figure 1 above summarizes the activities following the disposal of the rental properties. The cost base value is calculated by adding the ownership costs, disposal costs, and initial purchase costs. All these costs are then offset against the compensation Louisa’s obtained from the disposal of the rental property. Based on the calculations, Louisa’s suffered a net capital loss of 261,300 through the disposal of the asset at a lesser value than the market value which was approximately 1,700,000

Treatment for net capital Loss (9000) for 2020.

According to 1999, legislation on CGT, a prior loss in capital gains is carried forward and offset against the following year’s net capital gains¹⁷. Louisa should therefore carry forward the 9000 loss from the sale of shares to the financial year 2021. However, since she made a capital loss, the amount cannot be offset and thus added to the capital loss incurred and carried forward to the following year. The following will be the 2021 liability for the disposal of the asset;

Figure 2

Based on the findings in Figure 1 above, it is clear that Louisa had a capital loss and therefore cannot claim a discount of 50% having owned the property for more than 1 year. Since she cannot seek compensation, she will have to carry forward the loss to be offset in future transactions where she has a capital gain as per the CGT Australian regulations. The prior balance of 9000 which emanated from a loss will also be added to the current capital loss and offset against future capital gains.

References

Australian Government Tax Office, “Aust Tax Office – GST Seminars” (1999) 77(10) Australian Veterinary Journal

Kenny, Paul Laurence, “Capital Gains Tax Exemptions In Australia And New Zealand: Rationale And Reality” [2005] SSRN Electronic Journal

Kenny, Paul Laurence, “A Review Of The 1999 Australian Capital Gains Tax Reforms” [2003] SSRN Electronic Journal

Mossop, David, “The Judicial Power Of The Australian Capital Territory” (1999) 27(1) Federal Law Review

Smith, Julie, “Australian State Income Taxation: A Historical Perspective” [2015] SSRN Electronic Journal

ATO, “Capital Gains Tax”, Ato.Gov.Au (Webpage, 2021) <https://www.ato.gov.au/General/Capital-gains-tax/>

ATO, “Guide To Capital Gains Tax 2021”, Ato.Gov.Au (Webpage, 2021) <https://www.ato.gov.au/forms/guide-to-capital-gains-tax-2021/?=redirected_CGTguide>

ATO, “Capital Gains”, Ato.Gov.Au (Webpage, 2021) <https://www.ato.gov.au/Individuals/myTax/2020/In-detail/Capital-gains/>

ATO, “CGT Assets And Exemptions”, Ato.Gov.Au (Webpage, 2021) <https://www.ato.gov.au/General/Capital-gains-tax/CGT-assets-and-exemptions/>

ATO, “Your Home And Other Real Estate”, Ato.Gov.Au (Webpage, 2021) <https://www.ato.gov.au/general/capital-gains-tax/your-home-and-other-real-estate/>

ATO, “CGT When Selling Your Rental Property”, Ato.Gov.Au (Webpage, 2021) <https://www.ato.gov.au/General/Capital-gains-tax/Your-home-and-other-real-estate/Sale-of-property-and-other-CGT-events/CGT-when-selling-your-rental-property/>

“How To Calculate Depreciation: Straight Line, Diminishing Value Examples”, Guru99.Com (Webpage, 2021) <https://www.guru99.com/fixed-assets-and-depreciation.html>

Jones Day, “Australia Raises Capital Gains Withholding Rate”, Jonesday.Com (Webpage, 2021) <https://www.jonesday.com/en/insights/2017/08/australia-raises-capital-gains-withholding-rate-for-foreign-residents-in-real-estate-transactions>

Little Real Estate, “What Is The Capital Gains Tax? | Little Real Estate”, Little Real Estate (Webpage, 2021) <https://www.littlerealestate.com.au/news/what-is-the-capital-gains-tax>

Raises, Ken and Ken Raiss, “A Complete Guide To Capital Gains Tax (CGT) In Australia”, Property Update (Webpage, 2021) <https://propertyupdate.com.au/a-complete-guide-to-capital-gains-tax/>

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