Capital gains tax: main residence exemption - dwelling first used to produce income

Does section 118-192 of the Income Tax Assessment Act 1997 (ITAA 1997) apply in working out the capital gain or capital loss on the disposal of a dwelling that was a taxpayer's main residence but ceased to be so when, after 20 August 1996, the taxpayer vacated the dwelling and commenced renting it to tenants?

Yes. Section 118-192 of the ITAA 1997 applies. This means that, for the purpose of calculating their capital gain or loss on the disposal of the dwelling, the taxpayer is taken to have acquired the dwelling for its market value when they commenced renting it.

The taxpayer acquired a dwelling in 1990 which became their main residence.

The taxpayer vacated the dwelling in October 1996 and commenced renting it to tenants.

The dwelling ceased to be the taxpayer's main residence when they vacated it and they did not make a choice under section 118-145 of the ITAA 1997 to continue to treat it as their main residence.

The taxpayer disposed of the dwelling in September 2003.

Section 118-192 of the ITAA 1997 sets out a special rule which is applied in working out a capital gain or loss on a dwelling which has been a main residence and which has also been used for income producing purposes. That rule applies if: • only a partial main residence exemption would be available under Subdivision 118-B because the dwelling was used for the purpose of producing assessable income during the taxpayer's ownership period: paragraph 118-192(1)(a) • the income producing use started after 7.30 pm (by legal time in the ACT) on 20 August 1996: paragraph 118-192(1)(aa), and • the taxpayer would have been entitled to a full main residence exemption if they had entered into a contract to dispose of the dwelling just before the first time it was used for the income producing purpose: paragraph 118-192(1)(b).

If these conditions are satisfied, the taxpayer is taken to have acquired the dwelling at the time they first started using it for income producing purposes for its market value at that time: subsection 118-192(2) of the ITAA 1997. This has the effect that the first element of the dwelling's cost base and reduced cost base is the market value of the dwelling on the day it was first used for income producing purposes (and that expenditure incurred by the taxpayer prior to that day is ignored). History note The last sentence of the above paragraph has been rewritten to improve clarity

The first condition is that a partial main residence exemption is available because the dwelling was used for income producing purposes. It has been suggested that this condition is only satisfied if there is concurrent use of the dwelling as both a main residence and for the purpose of producing assessable income, such that a partial main residence exemption is available under section 118-190 of the ITAA 1997.

It could be argued that the condition is not satisfied in the present case, where the dwelling is used solely for producing assessable income after it ceases to be a main residence, such that a partial main residence exemption is available under section 118-185 of the ITAA 1997. It might be possible to conclude that the partial main residence exemption in that situation stems from the fact that the dwelling was not a main residence for the whole ownership period, whereas the condition requires the partial exemption to arise 'because' the dwelling was used for income producing purposes.

However, it is considered that the condition in paragraph 118-192(1)(a) can apply in a case such as this, where the income producing use of the property is incompatible with the taxpayer's continued use of the dwelling as their main residence. In that case, the partial exemption can be said to arise 'because' the dwelling was used for income producing purposes. That is, there is a direct nexus between the income producing use and the partial exemption.

For this taxpayer, the other conditions in section 118-192 are also satisfied. Accordingly, the taxpayer is treated as having acquired the dwelling on the day in 1996 that it was first used to produce assessable income. Further, they are taken to have acquired it for its market value on that day: subsection 118-192(2) of the ITAA 1997.

The taxpayer has not made a choice under section 118-145 of the ITAA 1997 to continue to treat the dwelling as their main residence during any of the period it was rented. Therefore, the effect of section 118-192 of the ITAA 1997 applying is that the capital gain or loss made by the taxpayer will broadly equal the difference between the market value on the day in 1996 when the dwelling was first used for income producing purposes and the amount for which the dwelling was sold in September 2003.

Note: ATO ID 2003/1113 explains the effect of section 118-192 of the ITAA 1997 when the taxpayer makes a choice under section 118-145 of the ITAA 1997.