Capital gains tax refers to a type of tax levied on capital gains incurred by organizations or individuals. The capital gains refer to the profits that an organization or individual selling a capital asset obtains through selling an asset at a price higher than the original price. In many countries, the amount of capital gains tax takes into consideration the type of investment and the holding period of the asset. Australian capital gains tax takes a proportion of all achieved capital gains. Capital gains are not separate tax but part of the income tax on individuals and corporations upon disposing of capital assets. Australian capital gains tax exempts personal properties such as home, car, and furniture. Australian residents in any part of the world are subject to capital gains tax.
Issue 1. Moodly's Conversion of her main residence.
Moodly being a childcare worker, wishes to convert part of her main residence for establishing a childcare centre. She acquired her main residence in 2005, so many years after the capital gains tax law passes in Australia. This means Moodly property was subject to capital gains tax during the time she acquired them. Special rules regarding taxation apply when an organization or individual is disposing properties in Australia (Pricewaterhouse Coopers, 2006). Moodly's move to convert part of her main residence into a childcare subjects the property into capital gains taxation. This is because Moodly will make capital gains out of the property. According to OECD (2006), certain specific properties benefit from capital gains tax exemption. Otherwise, properties obtained after 1985 or properties that have undergone major changes and renovation are included in the capital gains tax bracket. It is from this fact that Moodly 25% conversion of the floor area of her main residence will face capital gains taxation. Under the ITAA 1997, (Paragraph 118-115 (1) (a)) the main residence is defined as a dwelling which a unit of accommodation that is a building of contained in a building. Capital gains tax laws in Australia exclude properties that worth less than $10,000. Moodly property worth more than the least amount that is not subject to tax and subject to capital gains taxation.
Personal use of a property does not attract capital gain tax, but using part of the property as a childcare center attracts capital gains taxation. According to subdivision 118-B of the ITAA 1997, once the conversion of a dwelling begins, the property is no longer considered to be a personal property for the purpose of the main residence. Australian capital gains tax law further limits the use of properties that cost less than $10,000 for personal use. If such properties fall under collectibles, the tax limit reduces to $500 unless an individual obtains them through bravery and valor. It is advisable for Moodly not to undertake the conversion of her main residence. 25% conversion of the floor area at $300,000 is uneconomical. Instead, Moodly should take advantage of the capital gains tax-free status she currently enjoys, sell the portion of the property and use the proceeds for a deposit in a new property. If the owner undertakes disposal of a part of the main residence, the individual will be entitled to a partial main residence tax exemption. Section (118-185 of the ITAA 1997) provides this. A new property that costs less or equal to $300,000 is economical than using the same amount for conversion of personal property. In order to continue to enjoy the capital gains tax-free main residence, Moodly should consider purchasing another property. OECD (2006) explains that, partial capital gains liability will arise if a taxpayer uses a property for business or other income-producing purposes. Future cash flow will not be enough to cater for tax deduction resulting from using part of her home for commercial services. Considering the implications from capital gains tax that will arise and the diminishing marginal value of the property, her transaction will not be sufficient to cover the costs for the extension.
Calculation layout: Cost of conversion $300,000
Selling a portion of the main residence: $500,000
Capital gains tax. 30% of $500,000= 150,000
50% discount by selling the property after 12 months. 50% of 150,000= 75,000.
Capital gains tax paid is 150,000-75,000= 75,000
Moodly capital gains. $500,000- 75,000= $425,000
Moodly makes capital gains in selling the portion of property rather than converting it at $300,000. Gains from selling compared to conversion is $425,000- $300,000= $125,000.
Issue 2. Property inheritance
The law requires that an individual dispose an inherited property 12 months from the time of acquiring it. According to the Australian government taxation office, disposal of inherited assets is subject to the normal rules and any capital gains an inheritor makes on disposal is subject to capital gains taxation. The law assumes that Moodly acquired the property on the day that her sister died. Section 128-15 (2) of the ITAA 1997 requires that the legal personal delegate or the beneficiary of a property is considered to have attained the property on the day the deceased dies. Moodly acquires the block land in March 1997. The law requires that property inherited after 1985 are subject to capital gains taxation. According to section 110-25 of the ITAA 1997 the payment of inheritance tax cannot be included as part of the cost base because it does not fall within any element of the cost base. In this regard, the first element of Moodly's cost base and reduced cost base is taken to be her deceased sister's cost base and reduced cost base of the asset on the day she died. Because Moodly's sister died before 21 Septemeber 1999, the tax law requires that Moodly use the indexation method to work out the capital gains when disposing the block land. The indexation method requires indexing the first element of the cost base from the date Moodly's sister acquired the block land. Special rules under section 118-195 ITAA 1997 requires that an inheritor to a property regardless of whether it is the main residence or not need to hold the property for 12 months from the date the deceased died. Abiding to these rules will enable an inheritor to obtain the 50% general CGT discount. According to Howarth (2009), gains on assets held for less than 12 months are not in the increased cost base or the 50% discount. Special rules for calculating the cost base are applicable in this case because Moodly inherited the block land after 20 August 1996. Determination of the acquisition cost that is the market value at the date of death is necessary.
The block land does not face diminishing returns and increases its value as time moves on. This implies that the inheritor will make capital gains upon disposing of the asset. Disposing the asset immediately after 12 months, results in a low incidental cost. At the same time, disposing it immediately means foregoing higher capital gains resulting from land appreciation over time. Section 118-195 (3) ITAA 1997 states that, any capital gains or capital loss the legal personal representative or inheritor makes when the asset passes to them, the law will disregard. Moodly as the beneficiary can include in the cost base of the land any expenditure that the legal personal representative to her deceased sister would have been able to include at the time the asset passes to her. Moodly can include the expenditure on the day the legal personal representative incurred it. In this case, Moodly sister died on 20 March 1997, this means that on 20 April 1997, legal personal representative pays $500 council rates for the land. A month later, the legal personal representative transfers it to Moodly whom the law will assume has acquired the property on 20 March 1997 (ITAA Act 1997 Section 128-15 (5)).
If moodly proceeds with the sale of the land in 14 June 2013, it will attract another incidental cost. The council rates for the land cater for incidental cost. Upon disposing of the property, Moodly will be subject to capital gains taxation. The capital gains implication of the property results from the gains the beneficiary will make when disposing the property at a higher at a price higher than the original cost. Incidental cost charges take place when a property changes ownership. Apart from capital gains tax, Moodly will incur the incidental charge when handing over ownership of the block land in the estate to a new owner.
Calculation layout: Initial cost of land $14,000
At the point of death Cost of land $32,000
Appreciation per year. 18,000/5 = $3,600
At the point of sale. Cost of land $450,000.
Appreciation per year. 450,000- 32,000= 418,000
The land appreciates at a higher rate than before the death of her sister. Selling the land at $450,000 enables Moodly to make capital gains.
Issue 3. Disposing an inherited gift painting.
Inheriting the painting from a friend gives capital gains to Moodly. When Moodly wants to sell off the painting at a higher cost…