Capital Gains Tax Pitfalls for Beneficiaries: What You Need to Know About Inherited Property
Receiving property as part of an inheritance can seem straightforward, but many Australians discover too late that significant tax obligations may apply when they decide to sell. Capital gains tax on inherited property catches countless beneficiaries by surprise each year, resulting in unexpected bills that could have been avoided with proper planning and knowledge of the rules.
Understanding Capital Gains Tax on Inherited Property
When you inherit property in Australia, you generally do not pay tax at the time of inheritance. However, capital gains tax may apply when you eventually sell or dispose of the property. The Australian Taxation Office has specific rules that determine whether you will face a tax liability, and these rules can be complex.
The key question is not whether you inherited the property, but rather how the deceased used it and when you choose to sell it. These factors determine whether you qualify for exemptions that could save you thousands of dollars in tax.
The Two-Year Rule: Your Window of Opportunity
If the property was the deceased’s main residence immediately before their death and was not being used to produce income, you may be fully exempt from capital gains tax if you sell (and settle) the property within two years of their death.
Many beneficiaries are unaware of this time-sensitive exemption and miss out on significant tax savings simply because they delayed the sale. Estate administration can be complex and time-consuming, which is why the Australian Taxation Office may allow additional time in appropriate circumstances.
Discretionary extensions are considered on a case-by-case basis and are not automatic. The ATO may take into account circumstances such as probate delays, legal disputes over the estate, serious illness, or other significant events that prevented the property from being sold within two years.
Generally, the ATO expects the property to be sold as soon as reasonably practicable once these issues are resolved. Delays caused by waiting for market conditions to improve, renovating the property, or inactivity by the executor or beneficiary are unlikely to support an extension.
The Foreign Resident Trap
A significant and often overlooked tax trap affects beneficiaries and deceased persons who are foreign residents.
Since 1 July 2020, if the deceased was a foreign resident at the time of death, the main residence exemption is generally not available, subject to very limited life-event exceptions.
Similarly, if you are a foreign resident when you sell an inherited Australian property, you are generally not entitled to the main residence exemption, regardless of how long the property was owned or occupied by the deceased. These rules have caught many Australians living overseas by surprise, particularly those who inherit a family home expecting it to be tax-free.
Partial Exemptions: Not All or Nothing
Not every inherited property qualifies for a full exemption, but that does not mean you will pay tax on the entire capital gain. Partial exemptions can be available when the property was not always the deceased’s main residence or was used to produce income for part of the ownership period.
To calculate a partial exemption, you need to determine the number of days the property was used as a main residence versus the total number of days it was owned. The taxable portion of your capital gain is based on the proportion of non-main residence days.
These calculations become more complex if you also use the property as your main residence after inheriting it, or if the property was previously inherited by the deceased from another estate. Professional advice is essential to ensure you calculate the exemption correctly.
Cost Base Considerations
Understanding the cost base of your inherited property is crucial for calculating any capital gain. The cost base is generally what the deceased originally paid for the property, plus certain costs such as legal fees and improvements made after 20 September 1985.
If the deceased acquired the property before 20 September 1985, it was a pre-capital gains tax asset while they owned it. In this case, the first element of your cost base becomes the market value of the property on the day the deceased died.
For properties acquired after 20 September 1985, your cost base is usually what the deceased’s cost base was on the day they died. This means you step into their shoes for tax purposes, inheriting not just the property but also their original acquisition costs.
As a beneficiary, you can also include in your cost base any expenditure that the legal personal representative of the estate would have included if they had sold the asset instead of distributing it to you. This might include conveyancing fees or other costs incurred during the estate administration.
The Discount Method Advantage
If the inherited property has been held for at least 12 months, you may be eligible for the capital gains tax discount. This discount allows Australian residents to reduce their taxable capital gain by 50 per cent.
For inherited property, the 12-month ownership requirement generally includes the period the deceased owned the property, provided they acquired it on or after 20 September 1985. This means you may qualify for the discount even if you personally have only owned the property for a short time.
What Happens If You Use the Property as Your Main Residence
If you move into the inherited property and use it as your main residence, you may be entitled to additional exemptions. The property must be used as your main residence and not used to produce income during this period.
When you eventually sell the property, you may need to calculate a partial exemption that takes into account both the deceased’s period of ownership (if it was not their main residence at the time of their death) and your own period of residence. This calculation considers how many days the property was a main residence for either of you compared to the total days of ownership.
The key point is that you must actually live in the property as your main residence. Simply owning it while maintaining another home elsewhere will not qualify you for this exemption.
Pre-Capital Gains Tax Properties
Properties acquired before 20 September 1985 receive special treatment under the capital gains tax rules. If the deceased acquired the property before this date, it is generally exempt from capital gains tax.
However, any major capital improvements or additions made on or after 20 September 1985 may be subject to capital gains tax. The Australian Taxation Office treats these improvements separately from the original property.
Common Mistakes to Avoid
Many beneficiaries make costly mistakes when dealing with inherited property. One of the most common is assuming that because they inherited the property, no tax will ever apply.
Another mistake is failing to keep proper records. You need to maintain documentation of the deceased’s original purchase price, any improvements they made, and all costs associated with the estate administration.
Some beneficiaries also fail to seek advice about the two-year rule and inadvertently miss the deadline for the full exemption.
The Importance of Timing
The timing of when you sell an inherited property can have significant tax implications. Selling within two years of the deceased’s death can provide a full exemption in many cases, while selling after this period may result in tax on some or all of the capital gain.
It is important to know that the property needs to have been sold, and settled by the two year anniversary of the date of death of the deceased, not just the contract signed (as is typically thee case with capital gains).
However, the decision should not be based solely on tax considerations. You need to weigh your personal circumstances, the property market, and your financial needs against the potential tax savings.
If you are approaching the two-year deadline and circumstances have delayed the sale through no fault of your own, you should document these circumstances carefully. This documentation may support an application for a discretionary extension.
Seeking Professional Advice
The rules surrounding capital gains tax on inherited property are complex and subject to change. Each situation is unique, and what applies to one beneficiary may not apply to another.
Professional tax advice is essential. A qualified adviser can help you determine whether you qualify for exemptions, calculate any capital gain correctly, and identify strategies to minimise your tax liability.
Planning Ahead
If you are concerned about the tax implications for your own beneficiaries, estate planning strategies may help reduce future capital gains tax exposure. However, tax should be only one consideration when planning your estate.
Key Takeaways: Protecting Yourself from CGT on Inherited Property
Inheriting property comes with both opportunities and obligations. While the Australian tax system provides generous exemptions for inherited properties, these exemptions come with conditions and time limits that must be understood and carefully managed.
The hidden tax traps around inherited property can result in unexpected tax bills if you are not aware of the rules. By understanding the two-year exemption window, the foreign resident restrictions, and the various partial exemptions available, you can make informed decisions about when and how to sell inherited property.
The most important step you can take is to seek professional advice as soon as possible after inheriting property. This advice can help you navigate the complex rules, maximise available exemptions, and avoid costly mistakes that could significantly increase your tax liability.
Paris Financial are here to assist with any of your queries regarding inherited property and capital gains tax. Contact us today for expert advice tailored to your specific circumstances.
Disclaimer: This information is general in nature and does not constitute tax advice. Capital gains tax outcomes depend on individual circumstances and current ATO rules. Professional advice should be obtained before making decisions.