Residential capital gains tax calculations clarified.

CGT event K7

It has been seven years since significant depreciation legislation changes were announced (in the May 2017 Federal Budget), affecting how plant and equipment depreciation is claimed. Section 40-27 of the Income Tax Assessment Act (ITAA 97) (effective 1 July 2017) prevents claiming depreciation on second-hand or previously 'used' plant and equipment assets. Increasingly, investment properties are being bought and sold under these amended depreciation rules.

The revised legislation allows some property investors to reduce their liability for capital gains tax (CGT) by claiming capital losses on denied plant and equipment depreciation deductions, referred to under CGT event K7.

CGT event K7 refers to the application of CGT legislation. This previously established term offers guidance on handling CGT events when plant and equipment deductions are disallowed, typically due to private or non-income-producing use. Recently, CGT event K7 was expanded to include a process for managing Division 40 plant and equipment assets that are no longer depreciable under the amended legislation.

This is pertinent when an investment property is sold, or a plant and equipment asset is disposed of.

The calculation used to quantify this capital loss is:

Capital loss = Opening value of Division 40 plant and equipment asset MINUS termination value of Division 40 plant and equipment asset at disposal or at the time property is sold

The capital loss schedule included in a BMT depreciation schedule simplifies the calculation of the opening (value at purchase) and termination values (value at sale) of Division 40 plant and equipment assets using an effective life depreciation methodology.

The un-deducted, written-down amount remaining doesn't always represent the asset's sale value. It is usually considered the case for residential property but is not always the case for larger assets that might retain value for other reasons.

When investors sell a rental property, they are often selling multiple assets. When calculating the CGT in simple terms, proceeds from the sale are allocated across assets. The same happens with the purchase price; the value of the plant at purchase is separated of the purchase price to show an amount attributed to the property (land and building) separately to the plant and equipment (depreciating assets).

Adjustments are then made to the cost base to calculate the capital gain or loss. Capital works deductions (Division 43) that were claimed or could have been claimed (TD2005/47) reduce the cost base. The capital gain can then be calculated considering any exemptions available, including the 50 per cent CGT discount for holding longer than 12 months.

As an example, a house was purchased for $500,000 in January 2019 and sold for $800,000 in January 2023. A total Division 43 amount of $300,000 meant a $7,500 capital works deduction was claimed each year, totalling $30,000 during the four years of ownership. The Division 40 plant and equipment deduction was initially valued at $30,000 at the time of purchase, but $20,000 of depreciation was denied and taken from the capital loss schedule, leaving an un-deducted value of $10,000 at sale in 2023. This $10,000 is often considered the plant and equipment value at sale. The Division 43 capital works deduction reduces the cost base for CGT purposes, thereby increasing the CGT liability on the property sale.

To calculate the CGT liability, the plant value is first separated from the purchase price: $500,000 minus $30,000 which equals $470,000. The Division 43 deductions claimed, reduces the cost base, so $30,000 is subtracted: $470,000 minus $30,000 equals $440,000. Next, the value of plant at sale is subtracted from the selling price: $800,000 minus $10,000 which equals $790,000.

The CGT liability is the difference between the leftover selling amount and the leftover purchase amount: $790,000 minus $440,000 which equals $350,000. Applying the capital loss for CGT event K7, the unclaimed depreciation is subtracted: $350,000 minus $20,000 which equals $330,000. Applying the 50 per cent CGT discount, the amount is halved: $330,000 x 0.5 which equals $165,000. If the owner is on a 37 per cent marginal tax rate, their tax bill increases by $61,050.

Accountants often mention that the CGT event K7 can result in a zero effect by simply adjusting the cost base. This is because any difference identified due to a reduced termination value of plant, increases the portion of sale price attributed to the property (land and building) when sold. This then often cancels out any capital gain adjustment for the plant and equipment, giving the investor the same result.

There are alternative scenarios where the capital loss schedule can also be of value.

1. If a property is partially CGT exempt due to its history as a primary place of residence, then CGT event K7 may still be applied to reduce any other CGT liabilities.

2. When an asset is scrapped throughout ownership, CGT event K7 can be applied to establish a capital loss in that year and used to offset a gain, even though the property was not sold.

3. When the contract date and settlement date for the sale of the property occur in separate financial years, a capital gain or loss from the property is calculated in the financial year of contract exchange, whereas CGT event K7 is calculated in the year of settlement. This means CGT event K7 could be used to offset any capital gains again within the settlement financial year or future financial years.

Calculating CGT for an investment property can be very complex, with varying outcomes depending on the application of capital losses, how often and how long someone lived in a property before it produced income, the duration of ownership and when it was purchased and sold. Therefore, the investor should consult an accountant for guidance when considering the potential CGT outcome of a transaction.

To ensure accuracy and to make life easy, all applicable BMT Tax Depreciation schedules include a detailed capital loss schedule in the appendix for your convenience.

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