CGT on Inherited Rental/Main Residence

Question

Dianne is the executor and beneficiary of Gary’s Will. Gary died on the 5 December 2018 leaving a residential property (“the property”) to Dianne. Dianne seeks advice in relation to the deceased’s estate’s potential liability for Capital Gains Tax following the proposed disposition of the property.

The background to the use and ownership of the property is as follows:

• Gary purchased the property with his then current wife Jenny in 2001 with a purchase price of $172,000.
• Gary and Jenny occupied the property as their principal place of residence until the dissolution of their relationship when Jenny moved out of the property in the year 2008.
• Gary continued to reside at the property and made a cash payment to his former wife Jenny and became the sole registered proprietor in 2009.
• Gary continued to occupy the property as his principal place of residence until December 2013 when he vacated the property to take up residence with his new domestic partner, Dianne.
• From December 2013 until the date of Gary’s death in December 2018, the property was rented out on a commercial basis as a residential tenancy. The property continues to be used as an ongoing residential tenancy, now being managed by Dianne as the executor of Gary’s estate.
• Dianne declared the value of the property for probate as having a value of $650,000 as at the 16 April 2019. This valuation was a current market estimate obtained from an estate agent.

Dianne seeks answers to the following questions:

1. What is the likely Capital Gains Tax liability of the estate following the disposition of the property?
2. How will that CGT liability be calculated, in view of the fact that there may be some entitlement to a partial principal place of residence exemption?
3. Will it make any difference whether Dianne disposes of the property by selling as the executor of Gary’s estate or disposes of it by transferring the property to herself as the beneficial owner and keeping the property as a commercial investment?

Answer

1. Section 118-75 ITAA 1997 https://www.ato.gov.au/law/view/document?docid=PAC/19970038/118-75   Gary receives the property on the marriage breakdown as if it had originally been purchased in his name only.  At the full price originally paid and he is deemed to have used it the same way as Jenny.  The cash payment to Jenny is a payment pursuant to the relationship breakdown not a purchase price of the house.
2. Section 118-192 ITAA 1997 https://www.ato.gov.au/law/view/document?docid=PAC/19970038/118-192  says that if up until the time Gary rented the property out it had always been covered by his main residence exemption then the cost base is reset to its market.  The catch is this line (so glad you are a solicitor)

   There is a special rule if:
   (a) you would get only a partial exemption under this Subdivision for a *CGT event happening in relation to a *dwelling or your *ownership interest in it because the dwelling was used for the *purpose of producing assessable income during your *ownership period; and

   Commentators are of the view that this reset disappears if you die because it requires you to first look forward to the time “you” sell it to see if you get a partial exemption and the deceased didn’t sell it.  Now you could argue that when section 128-15 says you inherit at the deceased’s costs base then it would be the resetted cost base.  And if you do go for a ruling on that I would like to know.  But for now I am going to assume Dianne is kicked out of this section and the cost base is $172,000.

3. Strangely enough there is no problem with the estate using section 118-145, the 6 years absence rule on the property while Gary lived with Dianne.   The catch is that this would expose Dianne’s home to full CGT during those years.  If Dianne lives in her property until she dies this CGT exposure will have no affect because her heirs will simply inherit the property at market value at her DOD, even though there would have been some CGT if she sold in her lifetime.

4. You might want to estimate the CGT liability before you decide which house to cover from 2013.  You will start with $172,000 then add to it everything that is associated with holding the property that has not been claimed as a tax deduction, this would be for the period 2001 to 2013 (section 110-25(4) ITAA but note these amounts cannot be used to calculate a capital loss).  Think about interest, rates, insurance, even cleaning and lawn mower fuel.  After 2013 most expenses would have been claimed against the rent but there may be some improvements.  Also any building depreciation claimable will have to reduce the cost base.  Consider buying and selling costs too.  It’s share of the probate cost can also be included in the cost base.
5. Once you have the capital gain for the whole period it is then apportioned between the number of days since 2001 covered by the main residence exemption.  Probably 2001 to 2013 and the number of days not covered 2014 to 2019 unless Dianne decides to expose her house.  The not covered percentage is applied to the capital gain then 50% CGT discount.  This means that expenses incurred while Gary lived there are proportionally used to reduce the capital gain on the period it was exposed and the holding costs were claimed as a tax deduction.   Note any capital losses Gary had can only be used in his DOD return not by the estate.
6. There will be no CGT triggered on the transfer from the estate to Dianne (reference section 128-10 ITAA 1997) but she will have to take it over at Gary’s cost base so lots of CGT when she sells.  She will still be entitled to use his main residence exemption for the period described above.   There is a small advantage if she sells it through the estate in the next few years in that the estate will be entitled to Gary’s tax free threshold etc for the first 3 tax returns after death, this may be less than Dianne’s but not really relevant if she wants to keep it as a rental.