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Mission possible: how you can claim CGT concessions on your next “rental” property sale

Tax Telegraph, November 2013

Most rental property owners have the understanding that they are not eligible to qualify for the small business Capital Gains Tax (CGT) concessions when their properties are sold. This is because most rental property owners do not even begin to assess their eligibility for these concessions.

However, not a lot of rental property owners realise that in certain circumstances their “rental” property may still quality for the concessions – which means you may be missing out on significant tax savings without even realising it!

Intrigued? Read on…

The active asset hurdle

Rental property owners have had the problem of satisfying the “active asset” test in order to apply for the small business CGT concessions. A property is an active asset when it is used in the course of carrying on a business. However, a property is excluded from being classified as an active asset if its main use is to derive rent (unless it is leased to a “connected” entity which is carrying on a business). This is regardless of whether the property is used in carrying on a business.

The following example is provided by the ATO to illustrate this point:

Rachael owns five investment properties that she rents to tenants under lease agreements that give the tenants exclusive possession. The lease terms vary from six months to two years. The properties are not active assets because Rachael uses them mainly to derive rent. This is the case even if Rachael rents the properties as a business activity.

Is your property a rental property?

The first thing to consider is whether your property even qualifies as a rental property in the strict sense, even if the payment received for the use of the property is technically called “rent”. In certain cases, even though you may think you are precluded from accessing small business CGT concessions because your rental property does not qualify, this fear may be premature as you may not even have a rental property on your hands in the first place!

To be excluded from being an active asset, the main use of your property should be to derive rent. To determine whether your property’s main use is to derive rent, the key factor to look at is whether the user of your property has the right to exclusive possession. If for example, your property is being leased under a lease agreement granting exclusive possession, the payments will most likely be rent and the property will not be “active”.

However, if the arrangement allows the person only to enter and use the property for certain purposes (e.g. holiday apartments, motels, commercial storage etc.), the property’s main use may not be viewed as deriving rental income. In this case, a landlord-tenant relationship will not technically exist and the owners will be considered to maintain possession of the property. This opportunity is often overlooked because in commercial parlance, many payments which are not “rent” in the relevant technical sense are called “rent”. These people may actually be carrying on a business which will result in the asset being considered active

For example:

Hire Space Pty Ltd carries on a business of providing domestic and commercial storage space on rent for periods ranging from one week to several years in exchange for a rental fee. Hire Space provides a 24-hour security service, cleaning service and office facilities. The company also provides trailers, trucks, trolleys, boxes for sale or hire.

Hire Space enters into a storage agreement with storage users for the right to enter and use the storage facilities, but there is no lease as such. The storage facilities will be treated as ‘active’ assets and the owners of Hire Space may be able to access the small business CGT concessions on sale of the property even though Hire Space is receiving “rent” for hiring out the use of their property.

Previous use as active asset

Many taxpayers may not be aware that a property does not have to be an active asset at the time of sale. If it satisfied the active asset test for a certain period during ownership, it will still constitute an active asset.

The active asset test requires the property in question to be an active asset for:

  • 7.5 years, if owned for more than 15 years, or
  • Half of the period of ownership if owned for 15 years or less.

Accordingly sometimes taxpayers may hold properties as active assets for a number of years before discontinuing their use as an active asset, but continuing passive ownership of the asset. These taxpayers should be aware that these properties may still qualify as active assets even years after they have ceased being used as active assets as long as they were an active asset for the periods specified above.

For example:

Norman purchased a property in 1999. Norman turned the property into a motel and ran a motel business called Bates Motel.

In 2009, Norman’s mother fell ill and Norman closed down Bates Motel to take care of his mother. From 2009 onwards Norman leased the property to Lila.

In 2013, when Norman’s mother died, he decided to sell the property. In this case, Norman has owned the property for 14 years (i.e. from 1999 – 2013). The property was an active asset for 10 years (i.e. from 1999 – 2009). Since the property was an active asset for more than half the period of ownership, the property will be an active asset when Norman decides to sell it in 2013.

Use by connected entity

Although assets whose main use is to derive rent are specifically excluded from being active assets, any such assets which are used in a business carried on by the taxpayer’s affiliate or an entity connected with the taxpayer, are deemed to be used by the taxpayer. This is confirmed by the Commissioner of Taxation in TD 2006/63, which states that if a CGT asset, such as land, is leased by a taxpayer to a connected entity for use in the connected entity's business, is not excluded from being an active asset of the taxpayer.

For example:

Rich Family Trust owns a property which it rents to Wealthy Co. Rich Family Trust does not carry on a business and therefore, prima facie, the property will not be an active asset.

However, Wealthy Co, which is an entity connected to Rich Family Trust, uses the property in a car dealership business. Therefore, the property will be an active asset for Rich Family Trust.

Mixed-use property

Rental properties which have mixed-uses can also qualify for the small business CGT concessions. For example, a property may be used partly for business and partly to derive rent. To determine whether the property satisfies the “active asset” test, things such as how the property areas are used and the levels of income derived from the different uses of the property will need to be considered. Even if more than half the property by area is used to generate rent, the CGT concessions may still apply to the whole property!

For example:

Kamal uses 45% of his property to conduct a café business and rents out 55% of his property to an unrelated third party who runs a news agency business. The income derived from the café business is 85% of the total income (i.e. business plus rentals) derived from the use of the property.

Although not a majority, a substantial area of the property is used to carry on a business. Also, the business part of the property derives most of the income for Kamal. According to the ATO rulings, it would not view Kamal’s property as having a main use of deriving rent. Thus the property would not be excluded from being characterised as an “active” asset and Kamal may be able to access the small business CGT concessions.

Conclusion

A lot of taxpayers may have a notion in mind that their rental property is not eligible for the very fruitful small business CGT concessions as their property does not satisfy the active asset test. However, not all “rental” properties will be barred from CGT relief.

The first question to consider is whether the arrangement you have in place is a genuine rental property arrangement or merely a hire situation.

Secondly you should consider the history of your property – was it ever used in a business, even if it was used in the business of an entity connected to you? Also consider how the property is used.

If you are looking to sell your rental property and any of the above strikes a chord, seek tax advice urgently. You may be entitled to substantial tax savings by accessing the small business CGT concessions.

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