New ATO guidelines provide greater CGT relief for inherited property

When an individual beneficiary or a Legal Personal Representative (LPR) inherits Australian residential property from a deceased estate, they may qualify for full or partial exemption from Capital Gains Tax (CGT) under an extension to the main residence exemption. Certain conditions must be met to be eligible for this tax relief. For instance, if the inherited property is sold within two years from the deceased's death (or within an additional timeframe permitted by the Commissioner), the beneficiary or LPR can secure a full CGT exemption.

In 2018, the Australian Taxation Office (ATO) released a draft Practical Compliance Guideline (PCG) which clarified the criteria for exercising discretion in extending the two-year time limit for disposing of the inherited property while still being eligible for a full CGT exemption. This draft was finalised on 27 June 2019, and introduced a new "safe harbour" compliance method. This method allows taxpayers to self-assess an extended period beyond the initial two years during which they can dispose of the property without incurring capital gains tax.

The Practical Compliance Guideline (PCG) offers guidelines on various circumstances, including those where the property was the deceased's main residence or was used to produce income, among other factors. These guidelines assist taxpayers and their legal personal representatives in understanding how to properly file their tax return concerning the inherited assets and any associated capital gain or loss.

For foreign residents or those unfamiliar with Australian tax law, it's advisable to seek professional advice to ensure compliance and maximise any potential exemptions.

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Tax tip – recent amendments improve the practical application

On 30 September 2022, the ATO's safe harbour guidelines scope was expanded to cover situations where COVID-19 lockdowns had caused delays in the disposal of inherited dwellings after the death of the original owner.

The background to applying the CGT rules to an inherited property

Specific provisions deal with the Capital Gains Tax (CGT) treatment of a dwelling that was the main residence of a deceased person. Where a dwelling (or an ownership interest in a dwelling) passes to an individual beneficiary or the LPR of a deceased taxpayer’s estate, special rules apply to:

• determine the acquisition time and cost base of the dwelling (or ownership interest) for the Legal Personal Representative (LPR) or beneficiary, and
• generally allow a full or partial main residence exemption when the LPR or beneficiary eventually disposes of the dwelling (or ownership interest)

Tax warning – certain foreign residents excluded

Foreign residents, specifically individuals classified as non-residents for Australian tax purposes, have been largely restricted from availing the Capital Gains Tax (CGT) main residence exemption for events at or after Since 7:30 pm on 9 May 2017. This was implemented with certain transitional provisions in place. Such a limitation can impact Legal Personal Representatives (LPR) and beneficiaries who inherit Australian residential property.

Specific rules dictate the deceased's cost base for the inherited property and constrain the potential for a full or partial main residence exemption. This is particularly relevant when the deceased, or, in particular circumstances, the beneficiary, was an excluded foreign resident, that is, an individual who has not been a resident for tax purposes for more than six years.

Special acquisition and cost base rules for an inherited property or an interest in a dwelling

Specific rules regarding acquisition and cost base come into effect when a residential property is transferred to a Legal Personal Representative (LPR) or an individual beneficiary as part of a deceased taxpayer's estate. These rules are contingent on two factors:

• The initial acquisition date of the dwelling by the deceased taxpayer
• The usage of the dwelling just before the taxpayer's passing

This means that:

a) Where the dwelling was acquired by the deceased pre-CGT (i.e., acquired by the deceased before 20 September 1985) – The LPR or individual beneficiary is taken to have:

• acquired the dwelling at the date of death;
• with a cost base (or reduced cost base) equivalent to its market value at that time

(b) Where the dwelling was acquired by the deceased post-CGT (i.e., on or after 20 September 1985) and was the deceased’s main residence just before death and not used for income-earning purposes – the LPR or individual beneficiary is taken to have:

• acquired the dwelling at the date of death;
• with a cost base (or reduced cost base) equivalent to its market value at that time

(c) Where the dwelling was acquired post-CGT and the dwelling was not the deceased’s main residence just before death and/or was being used for income-earning purposes – the LPR or individual beneficiary is taken to have:

• acquired the dwelling at the date of death;
• with a cost base (or reduced cost base) equivalent to the deceased’s cost base at the time of their death

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Tax warning – application to dwellings held as joint tenants

In the scenario where the deceased person owned a dwelling as a joint tenant (as opposed to a 'tenant in common'), the ownership interest automatically transfers to the surviving joint owner(s) without going through the deceased's estate.

In such cases, the cost base rules for a Legal Personal Representative (LPR) or beneficiary differ from those mentioned earlier. There is no market value uplift applied. Instead, for a post-CGT (Capital Gains Tax) dwelling, including one that was the deceased person's main residence before their death and not used for income purposes, the surviving joint tenant will assume a cost base (or reduced cost base) equivalent to the deceased person's cost base at the time of their death.

Despite being a surviving joint tenant, they may still be eligible to access the main residence concessions (such as a full or partial exemption) when they eventually sell the property. This is possible due to special rules that consider their interest as having passed to them as a beneficiary of the deceased's estate for these specific purposes.

Tax warning – special rules for certain foreign residents

The special cost base rule that allowed a market value uplift for a deceased's post-CGT main residence, which was not used for income purposes, is no longer applicable to Capital Gains Tax (CGT) events occurring at or after 7:30 pm on 9 May 2017.

This change specifically affects cases where the deceased person was classified as an 'excluded foreign resident'—meaning they had continuously been a foreign resident for more than six years—prior to their death. As a result, the beneficiary or Legal Personal Representative (LPR) is now considered to have acquired the deceased's post-CGT main residence for the cost base value at the date of death.

Transitional rules were in place (ignoring the excluded foreign resident exclusion) and broadly applied when a post-CGT dwelling was acquired before 9 May 2017 and was sold by either the LPR or the beneficiary by 30 June 2020.

Applying the full main residence exemption to an inherited property

Where an inherited property is disposed of, any capital gain or loss that arises on disposal (e.g., for an LPR or individual beneficiary) is eligible for a full exemption (i.e., the capital gain or capital loss is entirely disregarded) where both of the following conditions in S.118-195 are satisfied:

• The dwelling was either:
• acquired by the deceased taxpayer pre-CGT (i.e., before 20 September 1985); or
• acquired by the deceased taxpayer post-CGT (i.e., on or after 20 September 1985), and the dwelling was the deceased’s main residence just before death and was not used for income-earning purposes at that time
• Either of the following two requirements are satisfied:
• the ‘two-year requirement’ – The dwelling (or ownership interest) was sold within two years of the date of death (which is measured up until the settlement date for the sale) or within a longer period allowed by the Commissioner; or
• The ‘specified individuals requirement’ – The dwelling was the main residence of one or more ‘specified individuals’ for the entire period from the date of death until the settlement date when the dwelling was eventually sold. These individuals include:
• the deceased taxpayer’s spouse;
• an individual who had a right to occupy the dwelling under the deceased’s will; or
• a beneficiary who inherited the property disposes of the property.

Tax tip – temporary absence rule assists access to full exemption

To be eligible for a full Capital Gains Tax (CGT) exemption, a post-CGT dwelling must meet two criteria:

• It must have been the deceased person's main residence just before their death
• At that time, the dwelling should not have been used to generate income

The first criterion does not solely depend on whether the deceased physically resided in the dwelling before their death, but rather whether it was considered their main residence. This qualification can still be satisfied even if the dwelling is 'deemed' to be the taxpayer's main residence, as is the case when the dwelling is treated as their main residence under the 'temporary absence rule.'

Tax warning – special rules for certain foreign residents

If the deceased individual was classified as an 'excluded foreign resident' at the time of their death (meaning they had been a foreign resident for more than six continuous years), the full main residence exemption will not be available to the Legal Personal Representative (LPR) or the beneficiary(s). In this case, the deceased's status as an excluded foreign resident effectively takes precedence and prevents access to the full main residence exemption.

On the other hand, if the deceased was not an excluded foreign resident, but the beneficiary was one at the time of the relevant Capital Gains Tax (CGT) event (i.e., when the contract to sell the dwelling was made), the beneficiary may still potentially qualify for the full exemption. However, they must meet either the two-year or specified individual requirements. It's important to note that in these circumstances, the specified individual requirement is modified to exclude the beneficiary's use of the dwelling.

Applying the partial main residence exemption to an inherited property

If the full main residence exemption is not accessible, there remains a possibility for an individual beneficiary to qualify for a partial main residence exemption.

This situation could arise when, for instance, a dwelling that the deceased acquired and utilized as their main residence:

• Was not sold within two years after their death (without obtaining an extension from the ATO and without being eligible for the new 'safe harbour' approach); and
• Was not used as a main residence by a suitable specified individual for the entire period from the date of death until the settlement date of the dwelling's sale

When a partial main residence exemption is applicable concerning the capital gain arising from the disposal of a dwelling by a Legal Personal Representative (LPR) or beneficiary, the calculation of the portion of the capital gain considered for determining the individual's net capital gain for the year (referred to as the 'pro-rated capital gain') is as follows:

Pro-rated capital gain = Capital gain x Non-main residence days/Total days

When determining the pro-rated capital gain for a beneficiary or Legal Personal Representative (LPR), the calculation of non-main residence days and total days is generally based on the following criteria:

Dwelling (or ownership interest) acquired by the deceased pre-CGT – In this case:

• the non-main residence days are the number of days that the dwelling was not the main residence of a ‘specified individual’ (e.g., a spouse or beneficiary) from the date of death until the settlement date for the sale of the dwelling after death; and
• the total days are the number of days from the date of death until the settlement date for the sale of the dwelling after death.

Practically, this means that the period of ownership prior to death is ignored and the main residence exemption is generally only available for the number of days the dwelling was the main residence of a ‘specified individual’ (e.g., a spouse or beneficiary) after death (and not used for income-earning purposes).

For a dwelling (or ownership interest) acquired by the deceased post-CGT

• the non-main residence days are the number of days that the dwelling was not the main residence of the deceased (during their ownership period) and a ‘specified individual’ (from the date of death until the settlement date for the sale of the dwelling after death).
• the total days are the number of days from the date of acquisition of the dwelling by the deceased until the settlement date for the sale of the dwelling after death.

Practically, this means that the main residence exemption is is generally only available for the number of days the dwelling was the main residence of both the deceased (i.e., prior to their death) and a ‘specified individual’ (after death).

Importantly, there are a number of special rules which, where circumstances exist, operate to alter the relevant non-main residence days and total days used in calculating the pro-rated capital gain (as outlined above) on the disposal of a dwelling after death.

These include the following:

• If it produces a better result, the pro rata calculation formula can generally be adjusted for post-CGT dwellings by removing the ‘non-main residence days’ and ‘total days’ in the period after death, where the dwelling is disposed of within two years of the date of death (or within a longer period as allowed by the Commissioner or as applied under the ‘safe harbour’).
• Where the ownership interest was acquired by the LPR or beneficiary after 7:30 pm on 20 August 1996, the pro rata calculation formula is adjusted by removing the ‘non-main residence days’ in the period before death if the dwelling was the deceased’s main residence just prior to death and not income-producing at that time.
• The pro rata calculation formula must be further adjusted if the deceased acquired the dwelling through a deceased estate (e.g., the deceased acquired the property themselves as a beneficiary on or after 20 September 1985).

Next Steps

If you have inherited Australian residential property and are concerned with the potential CGT liability or you have inherited a pre CGT asset or have other questions about CGT implications, including how to calculate Capital Gains Tax, or if you are the executor of a deceased estate and need assistance in understanding the tax consequences, reach out to us today.

We have extensive experience dealing with inherited property and capital gains tax implications as well as rental properties that have been inherited as a result of deceased estates, including various life interest scenarios that can arise from such situations.

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