Recently we kicked off a series of discussions designed to help inform our readers regarding the tax treatment of property investing in 2021.
We are breaking it down into three stages being –
- Tax Implications of Investment Property Acquisition
- Tax Implications of Investment Property Ownership, and
- Tax Implications of Investment Property Disposal.
In our first post we started with the Tax Implications of Investment Property Acquisition looking at –
- Transfer Duty (previously known as Stamp Duty),
- Goods & Services Tax (“GST”), and
- Foreign Residents Withholding Tax
Then we moved onto the Tax Implications of Investment Property Ownership starting with –
- Goods & Services Tax (“GST”), and
- Land Tax.
Then we turned to –
- Income Tax (in Demystifying the Tax Implications of Property Investment in 2021 (Continued – Part 2)), and
- Negative Gearing (in Demystifying the Tax Implications of Property Investment in 2021 (Continued – Part 3)).
Then came Tax Implications of Investment Property Disposal again starting with –
- Goods & Services Tax (“GST”) (in Demystifying the Tax Implications of Property Investment in 2021 (Concluded – Part 1)).
So today we finish up with…
The ‘Income Tax’ Implications of Investment Property Disposal
First things first, the type of property you are disposing of has little impact on the income tax outcome. So we won’t be breaking things down into residential and non-residential properties on this occasion.
However what is important, is your intention regarding your investment property and the manner of disposal.
Profits Realised on the Sale of Property are Taxable
It is probably obvious, but when you dispose of a property for more than it cost you, the ‘profit’ is taxable and income tax will be payable unless an exemption applies.
The most obvious exemption is where you sell your home, but as we are focusing on investment properties, we won’t go into the details of the main residence exemption on this occasion.
How the profit is taxed on the disposal of a property that you held for investment purposes will come down to which of the following applies to you…
Profit Making Venture or a mere Realisation
Did you buy, hold and then sell the property with the primary intention of making a profit on its disposal?
Did you buy and hold the property in order to earn income from the investment (in the form of rent) and now you are selling in order to ‘merely realise’ your investment and convert it to cash?
Profit Intention – Taxable as Ordinary Income
If you purchased and then disposed of the property all as part of a strategy to make a profit, and any income (rent) you earned in the interim was merely incidental to your main purpose, then the ‘profit’ earned will be taxable as ordinary income.
That means all of that profit will be added to your taxable income and income tax will be paid on the entire amount at your applicable marginal tax rate.
The same applies if you are ‘in the business’ of property investment.
So even if you only transact on one property, if your intention is as above, the entire profit is taxable.
If you transact in multiple properties as part of a business, again, the entire profit is taxable (though the way your profit is calculated each year is slightly different, and trading stock rules will apply, though the principle is the same and all of the profit will be taxable).
Mere Realisation – Taxable as a Capital Gain
In contrast, if you purchased and held the property as part of a strategy of earning income (rent) from the investment, and then ultimately the time came to dispose of, and ‘merely realise’ the value of the asset, then the ‘profit’ earned will be taxable as a capital gain.
Now, many will have heard of ‘capital gains tax’. The truth is, the tax payable on a capital gain is not a different type of tax, capital gains tax doesn’t actually exist.
A capital gain is added to your taxable income and income tax is paid on the amount of capital gain at your applicable marginal tax rate.
So naturally, you are asking ‘what’s the difference and why does it matter’?
Capital Gains 50% Discount
The biggest difference between your property profit being taxed as a capital gain instead of as ordinary income is that –
- If the ‘profit’ is a capital gain, and
- You held the asset for more than 12 months, then
- The profit is ‘discounted’ by 50% (ie halved) and income tax is only paid on the remaining 50% (See the important point below if you held your property via a company).
Illustrative Example 4
You dispose of a property which you held for 2 years and upon that disposal you make a profit on the transaction of $100,000.
If when you acquired the property your primary intention was to ‘flip it’ and make a profit, then the profit will be considered ordinary income and tax will be payable on the entire $100,000.
Let’s say you are on the top marginal tax rate, which including Medicare Levy is 47%. In that case the total tax payable on the profit will be $47,000.
However, if when you acquired the property, and while you held it, you were primarily seeking the income (rent) from the investment, and the profit made at the end occurred when you ‘merely realised’ the asset into cash, then the profit will be treated as a capital gain.
As you held the property for more than 12 months, you will qualify for the 50% Capital Gains Discount. This means your ‘net’ capital gain is reduced from $100,000 to just $50,000.
At your marginal tax rate of 47%, the tax payable in this case is now only $23,500.
Other Differences in the Treatment of the Profit
The discussion above covers what is likely the most important difference between the two treatments for the majority of taxpayers. But there are other important differences.
The next most important difference is how tax losses can be used against the profit earned on the disposal of your investment property.
If you have capital losses to use, they can only be used against a capital gain.
If you have ordinary losses to use, they can be used against both ordinary income AND capital gains.
Can I Just Choose Which Treatment I Want
Well, sort of, but not really.
By that I mainly mean you can’t decide which one applies at the end when it comes time to sell.
The treatment will be determined on your intentions throughout the entire investment process as evidenced by the facts.
In some respects, you get to choose at the beginning, based on your intentions and how your behaviour demonstrates those intentions. But once you have ‘chosen’ a path so to speak, there is little scope to change.
Capital Gains in a Company
If your property investment profit is earned via a company structure, unfortunately the 50% capital gains discount does not apply. In this case, the practical difference between a profit making venture and a mere realisation is nil. Though how your losses can be used is still impacted as described above.
Concluding our Series on the Tax Implications of Property Investments in 2021
So that wraps up our series regarding the tax implications of property investment in 2021.
Of course not every scenario or consideration has been addressed, and the real world rarely fits into the simplified scenarios we have discussed.
Therefore if you are considering a strategy of wealth building through property, or have already begun, we encourage you to get in touch and seek formal advice regarding all of your tax implications.
Because not doing so will almost certainly result in some unpleasant surprises at some point along the way.