Capital gains tax: main residence exemption: interaction between the 'absence' rule and the 'first use to produce income' rule - dwelling used to produce income for more than six years

Can a taxpayer choose under section 118-145 of the Income Tax Assessment Act 1997 (ITAA 1997) to treat a dwelling as their main residence while they use it to produce assessable income if they are also treated, under the rule in section 118-192 of the ITAA 1997, as having acquired the dwelling for its market value when they first used it to produce income?

Yes. A choice can be made under the 'absence' rule in section 118-145 of the ITAA 1997 even though the 'first use to produce income' rule in section 118-192 of the ITAA 1997 also applies. However, under subsection 118-145(2) of the ITAA 1997 the maximum period the dwelling can be treated as the taxpayer's main residence while it is being used to produce assessable income is six years.

The taxpayer purchased a dwelling in Australia in September 1994 and immediately started using it as the taxpayer's main residence.

In September 1996, the taxpayer moved overseas to work and began renting the dwelling to tenants.

The taxpayer continued to rent the dwelling until it was sold in September 2004.

The taxpayer did not acquire a main residence overseas - the taxpayer resided in accommodation supplied by their employer. Therefore, the taxpayer would like to choose to continue to treat the dwelling in Australia as the taxpayer's main residence for the first six years it was rented.

The first issue is whether section 118-192 of the ITAA 1997 applies. If it does, the second issue is whether (and how) section 118-145 of the ITAA 1997 applies in working out the capital gain or loss.

If a main residence is first used to produce income after 20 August 1996, there is a special rule in section 118-192 that affects the way in which a capital gain or loss is calculated when the residence is sold.

Under the rule 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 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 a taxpayer's ownership period: paragraph 118-192(1)(a) of the ITAA 1997 • the income producing use started after 7.30 pm (by legal time in the ACT) on 20 August 1996: paragraph 118-192(1)(aa) of the ITAA 1997, 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 they used it for the income producing purpose: paragraph 118-192(1)(b) of the ITAA 1997.

The taxpayer must first work out whether their income producing use of the dwelling would have resulted in them obtaining only a partial main residence exemption. They do this by applying the capital gains tax (CGT) main residence exemption rules (other than the rule in section 118-192 of the ITAA 1997).

Under those rules, a taxpayer can choose to continue to treat a dwelling as their main residence after it has ceased to be their main residence, provided the taxpayer does not treat any other dwelling as their main residence during this period: subsections 118-145(1) and (4) of the ITAA 1997. However, under subsection 118-145(2) of the ITAA 1997 the maximum period for which an income producing dwelling can be treated as a main residence is six years:

The taxpayer rented the dwelling for eight years from September 1996 until September 2004. The taxpayer would therefore be entitled to only a partial main residence exemption on any capital gain or loss made on the sale of the dwelling. The first condition in section 118-192 of the ITAA 1997 is satisfied.

The taxpayer started using the dwelling to produce income after 20 August 1996 and would have been entitled to a full main residence exemption if the taxpayer had entered into a contract to dispose of the dwelling just before it was first used for income producing purposes. The second and third conditions in section 118-192 of the ITAA 1997 are also satisfied.

Accordingly, the rule in section 118-192 of the ITAA 1997 applies and under section 118-192(2) of the ITAA 1997 the taxpayer is taken to have acquired the dwelling for its market value on that day in September 1996 when the property was first used to produce assessable income:. Note: Had the taxpayer rented the dwelling for less then six years before the dwelling was sold, the taxpayer would have been entitled to a full main residence exemption as a result of making a section 118-145 of the ITAA 1997 choice. In that case, section 118-192 of the ITAA 1997 would not apply.

The taxpayer can make a choice under the absence rule in section 118-145 of the ITAA 1997 even though section 118-192 of the ITAA 1997 applies.

This is so even though the choice can be made only by a taxpayer for a dwelling that has ceased to be the taxpayer's main residence and even though the dwelling was not the main residence during the taxpayer's new ownership period under section 118-192 of the ITAA 1997.

Denying the application of section 118-145 of the ITAA 1997 in such cases essentially renders that provision ineffective whenever a dwelling goes from being entirely exempt to entirely income producing and that income producing use lasts for more than six years. This is contrary to the plain words of section 118-145 which cap the choice at six years if any single period of income producing use lasts longer than that, but does not operate so as to deny any benefit from the choice if the dwelling is used for income producing purposes for more than six years.

Support for this view can be found in the wording of the equivalent provisions in the Income Tax Assessment Act 1936 (ITAA 1936). When the first use to produce income rule was introduced in subsection 160ZZQ(20D) of the ITAA 1936 (rewritten as section 118-192 of the ITAA 1997) a consequential amendment was made to the absence rule in subsection 160ZZQ(11) of the ITAA 1936 (rewritten as section 118-145 of the ITAA 1997). The amendment ensured that in determining whether the absence rule could apply, subsection 160ZZD(20D) of the ITAA 1936 was disregarded. In other words, the absence rule could apply even if the first use to produce income rule applied.

Paragraph 5.65 of the Explanatory Memorandum to Taxation Laws Amendment Bill (No. 3) 1997 which introduced subsection 160ZZQ(20D) of the ITAA 1936 says: Paragraph (a) of subsection 160ZZQ(11) is amended to ensure that a reference to a dwelling ceasing to be the sole or principal residence of the taxpayer in subsection 160ZZQ(11) applies regardless of new subsection 160ZZQ(20D) deeming the taxpayer to have acquired the dwelling at the same time.

When the relevant provisions were rewritten into the ITAA 1997, no change in meaning was signalled. Accordingly the taxpayer can choose to treat the dwelling as the taxpayer's main residence for the first six years after they start using it to produce assessable income. This is the basis on which the taxpayer works out their capital gain or loss under the formula in subsection 118-185(2) of the ITAA 1997.

The numerator in the formula is the non-main residence days. This is the number of days in the period from September 2002 (the end of the six year period) until September 2004 (when the dwelling was sold). The denominator is the days in the taxpayer's ownership period. This is the number of days in the period from September 1996 (when the taxpayer is now taken to have acquired the dwelling) and September 2004 (when the dwelling was sold).