Rentvesting is a tax strategy many Perth tax accountants use to eliminate private debt on the family home while maintaining the main residence exemption for capital gains tax. While the tax advice on the strategy is complex, it is worthwhile to understand the full range of tax implications and financial implications many Perth tax accountants will raise when talking about reinvesting.
The heart of the tax strategy
Australian tax law does not apply capital gains tax when selling the family’s main residence. So, if a family lives in a home and later sells it, capital gains tax will generally not apply to the net capital gain on the sale.
The concept of rentvesting uses the capital gains tax strategy of the main residence exemption and the income tax strategy of negative gearing combined.
While the concept is simple, it is worth knowing that the capital gains tax exemptions on the sale of the family home are among the most generous tax concessions available under Australian tax law. This generosity of the tax concessions also creates many complexities as the tax law is then written to prevent tax avoidance. Creating fairness for the complexity of life and the changing nature of the family home is also complex.
The main residence is not always where you live
When the tax law was written, the government acknowledged that people and families are mobile. And the family home might not always be occupied by the family. If a family relocates to a new area, possibly due to work, the family home will remain the family home and should still be able to be sold later on, free of capital gains tax.
This area of law (s118-145) allows a person to live in a home, leave that home for up to 6 years, and sell that family home tax-free using the main residence exemption.
While the family home does not have to be the home you live in – your family can only enjoy one home free of capital gains tax using the main residence exemption. So many families in business will engage with their Perth tax accountant to create a timeline of movements among properties so they can see how the main residence exemption has been applied across different home.
The rent vesting basic case
The concept of rent-vesting is that a person will move into a family home, make it their home, and then rent the home out while living elsewhere. This “somewhere else” could be the parents’ home or sharing with a friend.
The family home (now a rental property) can then be rented for up to 6 years. This allows the owner to enjoy both negative gearing tax benefits and capital gains tax exemption through the main residence exemption.
This is a classic case of how many families in business help the next generation get their first home.
The downsides of rentvesting
If you want to rentvest you must live in the family home. Sadly, tax law is littered with tax cases of people who have “lived” in a family home but somehow never used water or power. Alternatively, we have seen tax cases where the metadata of the taxpayer’s phone indicated that they only lived in the family home once a week.
The need to live in the family home is essential not only for the main residence exemption for capital gains tax purposes but also if you are applying for first home buyers grants or stamp duty exemptions.
Rentvesting and getting married
A family can only have one family home. A family can be a single adult with no children. However, a family is also a couple. In effect, two “families” become one “family” – so both spouses of the couple must choose one of the homes that will be the family home. One of the homes will ultimately become taxable on sale.
The choice of the family home for the main residence exemption only needs to be made once the home is sold. This choice is made within the income tax return that is lodged and prepared by the Perth tax accountant.
Another choice is that each spouse can choose for their former family home now to enjoy only half of the tax exemption on sale. This way only one combined home will enjoy the main residence exemption.
What is negative gearing?
Negative gearing occurs when an investment’s annual expenses surpass its generated income, allowing the investor to deduct this loss from their other income for tax purposes.
While commonly linked to property investments, negative gearing can apply to various investment types, including stocks. This concept aligns with Australia’s broader tax framework, where individuals and businesses deduct expenses before paying taxes on their net income. Negative gearing acknowledges the varying costs individuals incur in generating income.
Negative gearing has been part of Australian taxation since the 1930s, introduced in the Income Tax Assessment Act of 1936. Attempts to abolish it have been met with strong opposition from voters, ensuring its continuation. Australia is one of the few countries to employ a negative gearing policy, which some critics argue contributes to rising property prices. However, its effect on housing affordability remains contested, with others pointing to supply and demand as a more significant factor.
Understanding Negative Gearing
Negative gearing occurs when the costs of maintaining an investment property (like agent fees, mortgage interest, and maintenance expenses) exceed its rental income. For example, if a property brings in $10,000 annually but incurs $15,000 in expenses, there’s a $5,000 loss. This loss can be deducted from the owner’s taxable income. So, if their income is $100,000, they can reduce it to $95,000, lowering their income tax and effectively keeping more income.
Benefits of Negative Gearing
The primary advantage of negative gearing is its potential to reduce taxable income. It can be a strategy to leverage the bank’s money for wealth growth. For instance, if a property’s growth and income yield 10% on a 5% loan, the investor benefits from the difference.
Drawbacks of Negative Gearing
Negative gearing is less beneficial for those in lower tax brackets, like retirees or unemployed individuals, especially if their investment doesn’t appreciate quickly. It’s vital to note that while negative gearing offers tax savings, these refunds may be delayed, requiring investors to have sufficient cash flow to support the strategy.
Taxpayers must also be confident in the long-term capital growth of their asset, as these upfront losses are meant to be temporary. In Perth for example, capital growth on housing assets has ordinarily been stagnant for an extended period coupled with a short period of rapid capital growth. So negative gearing during a long period of stagnant growth has reduced the cost of holding the property – but it has still cost money to hold the property with no increase in capital value.
In this instance, getting investment advice from a real estate agent, valuer or property buyer agent is essential to choosing an investment property. Some financial planners give advice on finding a strong investment property (most focus on ASX shares, managed funds etc).
Is negative gearing guaranteed?
The above comments are general only. The tax benefits of negative gearing don’t work if you are focused on holding the property to a certain point when you will change it to the family home. They might also fail if you are a non-resident, pay interest offshore or attempting to negative gear in trusts and other structures.
What is the advanced case of rent-vesting?
Ordinarily, the taxpayer will live with the parents while renting out their family home. However, the investor can also pay rent to a third-party landlord and rent out the family home. This is usually done when the family home is in a desirable suburb with an older home, and the investor rents a smaller (cheaper) apartment.
The advanced case of rentvesting is that the home that is lived in (say the small flat) is now owned by a related party. The related party could be the parents who ultimately intend to pass on the apartment and the tax benefits enjoyed by the investor later. It can also be a situation where a family trust, controlled by the investor, also owns the apartment.
Care must be taken when forward planning the ownership of the property in the related party so that land tax costs are factored into the tax strategy for property acquisitions.
The related party cannot be a SMSF unless the SMSF balance is substantial.
If the rented property is owned by an associated person, care must be taken, and tax advice should be given by a Perth tax accountant. In effect, tax law requires that the rent paid on the property is charged at market rates, and the dealings with the tenant and the related party are all done at arms-length. This includes both payment terms, contract terms and rent charged.
If say, the rent charged on the property is charged at 70% “mates rates” then only 70% of the interest and holding costs can be claimed.
Is rentvesting worth it?
The financial calculations for rentvesting as compared to outright ownership are complicated. And the number can easily be tortured so that the net outcome is a no-brainer for an aspiring investor. Getting an independent forecast of after-tax cashflow returns, including the benefits from the main residence exemption compared to the capital gains tax discount, from a Perth tax accountant is essential to answering this question.
Conclusion
Rentvesting is a classic tax strategy used by families in business to help the next generation succeed and move forward. However, the strategy is often poorly implemented, with an ocean of quasi-professionals giving tax advice on this topic. Using an independent tax advisory firm like Westcourt is an intelligent move. With our deep, proven tax knowledge, independent-only advice, global network and single focus on families in business, we are the smart choice when it comes to tax strategy on property investing and reinvesting – so why not give us a call?
