My house-mate bought an investment property in Canberra that is leased out to the Defence for 10 years. What is the long-term capital gain tax he would have to pay if he decides to sell the investment property after 5 years. Can he reduce the capital gain by including the mortgage in the cost base? Is he eligible for partial CGT exemption as he can never live in the apartment?Can he liquidate the funds from the offset account? Does offset account earn interest? Is it advisable to hold the property and buy a second investment property. What are the other investment choices to diversify the risk. He is single, 27 and does not plan to marry in next 3 years and has moderate risk appetite.
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Okay so quite a complex question with many elements. Firstly I am going to assume your house-mate is and will remain an Australian tax resident during his period of ownership of the investment property(s), as parts of the answer would differ for a non Australian tax resident.
Firstly capital gains tax is paid on the gain made on the investment that is sold. The gain is simply the difference between the cost base of the asset and the funds received on sale.
For example if the cost base is $70,000 and the sale proceeds received are $100,000 then the gain is $30,000. As long as your house-mate has held the property for longer than a year, he is eligible to apply the Capital Gains Tax discount of 50% and so he will only pay capital gains tax on half the gross gain – or in the example above $15,000. This is now termed his net gain and is the amount which is added as ‘’income’’ into his tax return.
How much tax he now pays depends on his marginal rate of tax. For example if he has an annual salary of $100,000 – this will put him into the second highest tax bracket and will pay 37c in the dollar on his net gain of $15,000 (plus medicare levy).
This situation is the same whether he holds the property for 5 or 10 years – it will make no difference to the way the capital gains tax is calculated. The partial CGT exemption that you mention relates to an extension of the main residence exemption contained in s118-145, where you can treat a dwelling as your main residence and avoid capital gains tax on any gain for; up to 6 years if you are renting the residence out, or indefinitely if you are not. However, there are a number of conditions that must be met before this exemption can be applied – one of which is the requirement that the property was originally the main residence of the owner. As your house-mate never lived in this property he is not eligible for this exemption.
There a number of costs that can be added to the cost base of the property which can help reduce capital gains tax. One of which is the interest component (but not the capital repayment) of the mortgage payments. However any cost that has or can be used as a deduction in prior year returns is not able to be added to the cost base. In your mate’s case as he has been renting his property to Defence he would have been claiming this interest cost as a rental expense and so these costs cannot be added to the cost base for him.
An offset account does not earn interest, instead the balance in the offset reduces the interest charged on the loan it is ‘’offsetting against’’. With regards to liquidating the funds out of the offset account – this is fine, your mate can take what he wants out of this account and it does not affect his tax situation at all. Note however, if he was taking cash out of his loan account (effectively a redraw) rather than his offset – the interest on the mortgage would become partly non-deductible against the rental income of the property (unless the funds were used to improve the property). This is because whether interest is deductible depends on the purpose of the borrowings.
Additional investments particularly while increasing diversification is always a good idea. This could be done with another property, in a different location, or through managed funds, which can provide access to a range of assets including shares both Global and Australian, commercial property and fixed interest that are structured in line with his moderate risk appetite. It is always important to consider the purpose of the investment (Growth or income) the risk associated and the timeframe.