INTRODUCTION TO CAPITAL GAINS TAX
INTRODUCTION TO CAPITAL GAINS TAX
Queensland University of Technology QUT Business School School of Accountancy AYB 219 Taxation Law Lecture 7 Semester 1, 2021 INTRODUCTION TO CAPITAL GAINS TAX 1.0 INTRODUCTION 2.0 STEP 1: DOES THE ACT OR TRANSACTION INVOLVE A CGT EVENT? 2.1 What is a CGT Event? 2.2 CGT Event A1: Disposal of a CGT Asset 2.3 CGT Event C1: Loss or Destruction of a CGT Asset 3.0 STEP 2: DOES THE CGT EVENT INVOLVE A CGT ASSET? 3.1 What is a CGT Asset? 4.0 STEP 3: DOES AN EXEMPTION OR CONCESSION APPLY? ExemptionsConcessions 5.0 STEP 4: DOES A ROLLOVER PROVISION APPLY? 5.1 Disposal of an Asset by an Individual to a Wholly-Owned Company Disposal of an Asset from a Partnership to a CompanyReplacement Asset Rollover EventsSame Asset Rollover EventsOn Disposal of a Small BusinessSmall Business Restructure RolloverEffect of Rollover 6.0 STEP 5: DOES A CAPITAL GAIN OR A CAPITAL LOSS ARISE FROM THE CGT EVENT? Capital ProceedsCost BaseIndexed Cost BaseReduced Cost Base 7.0 CALCULATING CAPITAL GAINS Choice of Two MethodsThe Indexation MethodThe CGT Discount Method 8.0 APPLYING CAPITAL LOSSES AGAINST CAPITAL GAINS
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9.0 SUMMARY AND CONCLUSIONS Objectives of Lecture 7:At the end of this lecture, you should be able to:understand the broad underlying concepts of capital gains tax and the steps involved in determining a taxpayer’s liability for CGT; identify and explain the various CGT events; identify the different types of CGT assets; outline some of the common CGT exemptions that exist; explain how capital gains and losses are treated; and calculate a taxpayer’s capital gain and capital loss from a CGT event.Lecture 7 Reading:2021 Australian Master Tax Guide: Chapter 11 “Capital Gains Tax: General Topics”, paragraphs 11-000 to 11-050, 11-240 to 11-250, 11-270, 11-380, 11-500 to 11-570, 11-610 to 11-660. 1.0 INTRODUCTION Prior to 20 September 1985, capital gains were not taxed in Australia. Taxation of capital gains was introduced into Part IIIA (comprising Sections 160A to 160ZZU) of the ITAA (1936) from 20 September 1985 to remove an unfair advantage that existed if a taxpayer derived a capital amount (which was tax-free) compared to another taxpayer who derived income amounts (which were taxed). Under the ITAA (1936), the sections relating to capital gains tax became cumbersome and tedious. For example, sections included: Section 160ZZRAA (exemption of goodwill for CGT purposes); andSection 160ZZPZD (rollover relief for small business assets). As a result, the capital gains tax provisions were re-written in 1998 and are now found in Parts 3-1 and 3-3 of the ITAA (1997). This comprises Divisions 100 to 152. It should be noted that the capital gains tax regime is part of the ITAA (1997) and is not a separate tax or taxing Act in its own right. Capital gains tax is essentially a tax that applies in respect of the disposal of a capital asset acquired on or after 20 September 1985 where the realisation is notundertaken in the ordinary course of carrying on a business. If the asset is disposed of in the ordinary course of business, capital gains tax will not apply. Instead, the gain will be fully assessable under Section 6-5 of the ITAA (1997). Hence, land sold by a property developer would constitute a disposal of trading stock, not a disposal of a CGT asset. The gross sale of the land would be assessable under Section 6-5, the purchase of the land would be deductible under Section 8-1 and the opening and closing stock would be dealt with under the trading stock provisions contained in Division 70 would apply. Assets acquired prior to 20 September 1985 (ie. 19 September 1985 and before) which are subsequently sold are exempt from capital gains tax and are referred to as pre-CGT assets. Conversely, assets acquired on or after 20 September 1985 which are subsequently sold are subject to capital gains tax and are referred to as post-CGT assets. The effect of the CGT regime is that the net capital gain arising from the disposal of a CGT asset becomes statutory income and is included in the taxpayer’s assessable income by virtue of Section 102-5 of the ITAA (1997). The net capital gain is included at Item 18 of an individual taxpayer’s income tax return and added to the taxpayer’s taxable income and taxed at the taxpayer’s marginal tax rate. Under the ITAA (1997), the CGT decision-making process is a five-step process. The following questions need to be asked: (i) Does the act or transaction involve a CGT event? (ii) Does that CGT event involve a CGT asset? (iii) Does an exemption or a concession apply to the CGT event? (iv) Does a rollover provision apply? (v) Does a capital gain or a capital loss arise from the CGT event? These steps are discussed in turn. Diagram 1 below summarises these five steps. Diagram 1: How Capital Gains Tax Works 2.0 STEP 1: DOES THE ACT OR TRANSACTION INVOLVE A CGT EVENT? 2.1 What is a CGT Event? According to Section 102-20 of the ITAA (1997), a capital gain or loss can only arise if a CGT event happens. There are twelve (12) categories of CGT events comprising 56 individual CGT events in all. Division 104 contains a complete list of all the CGT events which can give rise to a capital gain or loss. The twelve categories of CGT events contained in Section 104-5 of the ITAA (1997) are summarised in Table 1 below. Table 1: CGT Events CGT EventDescriptionEvent A1 Event B1 Events C1 to C3 Events D1 to D4Events E1 to E9Events F1 to F5 Events G1 and G3Events H1 and H2 Events I1 and I2 Events J1, J2, J4 to J6 Events K1 to K12Events L1 to L8Disposal of a CGT asset Hire purchase and similar arrangements CGT assets lost, destroyed, cancelled or finalised Creating of contractual or other rights, granting options, granting a right to income from mining Creating a trust over a CGT asset, transferring a CGT asset to a trust, converting to a unit trust, capital payments, beneficiaries becoming entitled, creating a trust over future property. Granting or discharging a lease. A non-assessable amount paid to a shareholder, a shift in share values and a declaration by a liquidator that shares in a company are worthless. Forfeiture of a deposit and a capital receipt relating to a CGT asset. When an individual, company or trust stops being an Australian resident. Changes in the relationships following rollovers. Miscellaneous events, including partial realisation of intellectual property, CGT asset starts being trading stock, venture capital investments, payments from a bankrupt etc. Consolidated groups Some events, such as the disposal of a CGT asset, occur frequently, while other events have limited application. For each event, Division 104 outlines: the cause (description) of the event;the timing of the event (ie. when did the CGT event occur?); andthe amount of any capital gain or capital loss resulting from the event. Each CGT event has its own rules for determining the timing of that event. In this lecture, we will consider the two most common CGT events, namely: A1: Disposal of a CGT Asset; andC1: Loss or Destruction of a CGT Asset. 2.2 CGT Event A1: Disposal of a CGT Asset CGT Event A1 is the most common CGT event. CGT Event A1 occurs where a taxpayer disposes of a CGT asset (Section 104-10). The most common way that an asset is disposed of under CGT Event A1 is by way of sale, transfer, exchange or by being gifted to someone. A disposal occurs where there has been a change in the legal and beneficial ownership of the asset (Section 104-10(2)). The first question that CGT Event A1 addresses is the timing of the CGT event when an asset is sold. The date could either be the: the date of the contract; orthe date of settlement? According to Section 104-10(3), the disposal of an asset under CGT Event A1 occurs: when you enter into the contract for the disposal of the asset (ie. the date of the contract); or if there is no contract – when the physical change of ownership occurs (usually the date of settlement). Hence, for CGT purposes, a disposal of an asset is deemed to have occurred when the contract is signed and not when settlement takes place. 2.3 CGT Event C1: Loss or Destruction of a CGT Asset CGT Event C1 happens if a CGT asset owned by a taxpayer is lost or destroyed (Section 104-20). The time of the event depends on whether the taxpayer receives compensation for the loss or destruction of the asset. Taxpayer is Insured: If the taxpayer receives compensation (insurance) for the loss or destruction of an asset, CGT Event C1 is deemed to occur when the taxpayer first receives compensation (insurance). Example 1 (Insured):On 17 June 1998, Lauren acquired a factory under a contract of purchase for $1,000,000. On 1 May 2020, Lauren’s factory is completely destroyed by a fire. The good news is that Lauren has an insurance policy covering such unforeseen circumstances should building be damaged or destroyed.Assume that Lauren received $2,400,000 in compensation from her insurance company on 1 August 2020.As Lauren was insured and received compensation, CGT Event C1 is deemed to have occurred on 1 August 2020, not on 1 May 2020 when the fire occurred. Lauren’s gross capital gain is $1,400,000 (ie. $2,400,000 – $1,000,000). She will include this capital gain in her 2021 income tax return. Taxpayer Not Insured: Conversely, if no compensation is received (ie. the asset was not insured), CGT Event C1 is deemed to have occurred when the destruction occurred, or if that is not able to be ascertained when the loss is first discovered. Example 2 (Not Insured):On 17 June 1998, Lauren acquired a factory under a contract of purchase for $1,000,000. On 1 May 2020, Lauren’s factory is completely destroyed by a fire. Unfortunately, Lauren has no insurance policy. The market value of the factory at the time of its destruction is $2,200,000.If Lauren did not have insurance, CGT Event C1 is deemed to have taken place on the date the factory was destroyed (ie. 1 May 2020).Lauren’s capital loss is $1,000,000 (ie. $0 – $1,000,000). If she has no capital gains to offset this capital loss against, she can carry this forward in future tax returns. The market value of the asset at the time of its destruction is irrelevant. According to Section 104-20(3), a taxpayer makes a capital gain from a CGT Event C1 if the capital proceeds from the loss or destruction of the asset is more than its cost base. Conversely, if the capital proceeds are less than the cost base (or reduced cost base) of the asset, a capital loss is made (refer Section 8.0). The market value of the asset at the time of the loss or destruction is irrelevant. 3.0 STEP 2: DOES THE CGT EVENT INVOLVE A CGT ASSET? 3.1 What is a CGT Asset? Understanding the meaning of the term CGT asset is the second essential step in the CGT process. To come within the CGT provisions, the asset must have been acquired on or after 20 September 1985 (ie. be a post CGT asset). A CGT asset is defined in Section 108-5(1) as any kind of property and extends to include legal or equitable rights that are not property. Section 108-5(2) extends the meaning of a CGT asset to include: (a) part of, or an interest in, a CGT asset covered by Section 108-5(1); (b) goodwill or an interest in goodwill; (c) an interest in an asset of a partnership; and (d) an interest in a partnership not covered by paragraph (c) above. A note to Section 108-5(2) gives the following examples of CGT assets: land and buildings (including rental properties);shares in a companyunits in a unit trust;rights and options;leases;goodwill;debts owed to a taxpayer;foreign currency; andcryptocurrencies (such as Bitcoin). Note that cash (expressed in Australian dollars) is not a CGT asset. Since 21 September 1999, a capital gain or loss arising from a CGT event in relation to a depreciating asset is exempt (Section 118-24). Hence, computers, photocopying machines, furniture and fittings are not subject to capital gains tax when sold, but may give rise to an assessable balancing adjustment under Section 40-285(1) or a deductible balancing adjustment under Section 40-285(2) of the ITAA (1997) when sold. Whilst a building is regarded as a depreciable asset for accounting purposes, a building is not regarded as a depreciable asset for the purposes of Division 40 of the ITAA (1997). Instead, it is subject to the special 2.5% capital works allowance as per Division 43 of the ITAA (1997). This is not the same as depreciation. Hence, the sale of a building will give rise to a capital gain or loss (provided it was acquired on or after 20 September 1985). 4.0 STEP 3: DOES AN EXEMPTION OR CONCESSION APPLY? 4.1 Exemptions Table 2 below lists the most common assets that are exempt from CGT under the Act. Table 2: List of CGT Exemptions SectionExemption118-5(a)118-5(b) 118-10(1) 118-10(3) 118-12 118-22 118-24 118-25 118-30 118-35 118-37(1)(a)118-37(1)(b)118-37(1)(c) 118-37(3) Subdiv 118-Ba car, motorcycle or similar vehicle designed to carry less than one tonne or fewer than nine passengers ** a decoration awarded for valour or brave conduct, unless purchased by the taxpayer a collectable acquired for a market value of $500 or less, exclusive of GST ** a personal-use asset acquired for $10,000 or less, exclusive of GST ** a CGT asset used solely to produce exempt income an eligible termination payment a depreciable asset disposed of after 21 September 1999 ** trading stock (inventory) ** film copyright research and development projects compensation or damages received by the taxpayer for any occupational wrong or injury compensation or damages for wrong, injury or illness suffered personally by the taxpayer or a relative gambling winnings or prizes ** compensation received under the firearms surrender arrangements an individual’s main residence usually to the extent that it has not been used for income-producing activities other than rental income where the main residence is rented for up to six years ** Anti-Overlap Provisions (to Prevent Double Taxation) There may be instances where an amount may be subject to income tax under a different provision of the Act and also subject to capital gains tax. In this instance, Section 118-20 provides that double taxation is avoided by making any amount included under the CGT provisions exempt. For example, the sale of trading stock would be assessable under Section 6-5. Hence, the sale of trading stock falls outsides the CGT provisions (see Section 118-25 above). 4.2Concessions CGT relief is also available where a small business is sold. For details on these concessions and whether they apply, refer to Division 152 of the ITAA (1997). These concessions are discussed in further detail in AYB 320 Advanced Taxation Law. 5.0 STEP 4: DOES A ROLLOVER PROVISION APPLY? In certain circumstances, the Act provides for a deferral of CGT. This happens in a limited number of rollover situations that usually occur where there is a change in the entity owning the CGT asset without a change in the underlying ownership of the asset. According to Section 122-25(2), certain assets are not subject to rollover relief. These assets include depreciating assets, trading stock, collectables and personal use assets. These assets are discussed in further detail in Lecture 8. There are only limited situations where CGT assets qualify for rollover relief. These situations are outlined in Divisions 122, 124, 125 and 126 of the ITAA (1997). Disposal of an Asset by an Individual or Trustee to a Wholly-Owned Company Rollover relief is available where a CGT asset is transferred by an individual (sole trader or a trustee of a trust) to a wholly-owned company. For the rollover to be effective, the individual or trustee must receive non-redeemable shares in the new company equivalent to the market value of the net assets of the previous business (Subdivision 122-A and 124-N). After the event, the transferor must own 100% of the shares in the newly established company. 5.2 Disposal of an Asset from a Partnership to a Company Rollover relief is available where a CGT asset is transferred by partners in a partnership to a wholly-owned company. For the rollover to be effective, all of the partners must receive non-redeemable shares in the new company of substantially the same market value as their respective interests in the partnership (Subdivision 122-B). The rollover is only available if all the partners make an election for the rollover relief to apply. 5.3 Replacement Asset Rollover Events According to Subdivision 124, rollover relief is available where there is an involuntary disposal of a CGT asset owned by the taxpayer that is: compulsory acquired by an Australian government agency; ordisposed of to an Australian government agency under the threat of compulsory acquisition and in return, the taxpayer receives money, another CGT asset or both. The money must be used to acquire another CGT asset within twelve (12) months before or after the CGT event occurs. Where the original asset was used in the business, the replacement asset must also be used in a business, but it cannot become trading stock, nor can it be a depreciating asset (Section 124-75). 5.4 Same Asset Rollover Events Rollover relief is available where: a CGT asset is transferred to a spouse or former spouse (married or defacto) because of a court order, binding financial agreement or an arbitral award entered into under the Family Law Act (1975) resulting from a marriage breakdown (Subdivision 126-A);a CGT asset is transferred between companies with 100% common ownership at the time of the trigger (Subdivision 126-B); orthere are changes to a trust deed of a complying approved deposit or superannuation fund (Subdivision 126-C). 5.5 On Disposal of a Small Business Rollover relief is available where the proceeds from the disposal of an active asset are reinvested in a replacement active asset (Subdivision 152-E). 5.6 Small Business Restructure Rollover Until 30 June 2016, CGT roll-over relief was only available for individual sole traders, partnerships and trusts that converted to a company structure. However, from 1 July 2016, Subdivision 328-G has been inserted into the ITAA (1997) to enable small business entities (defined as an entity carrying on business with an annual turnover of less than $10 million per annum) to disregard any capital gain or loss made on the transfer of their business or assets from any legal structure to any other legal structure. This is referred to as the “small business restructure rollover”. The rollover provisions only apply to certain “active assets” of a business. Such assets are normally CGT assets, depreciating assets, trading stock and other assets that are used in the course of carrying on a business. 5.7 Effect of Rollover As previously mentioned, where a rollover applies, the capital gain is deferred. Where a rollover happens, the asset held by the taxpayer after the rollover carries the same CGT characteristics as the asset held before the rollover. In other words, the “new” holder of the asset is deemed to have acquired the asset not on the date of the rollover, but on the date the initial holder acquired the asset. Hence, when a pre-CGT asset is rolled over, the asset remains a pre-CGT asset. This means that if a pre-CGT asset is rolled over and is subsequently sold by the “new” holder, it will be completely exempt from capital gains tax. Similarly, when a post-CGT asset is rolled over, the asset carries the same cost base and acquisition date as the asset in the hands of the original holder. 6.0 STEP 5: DOES A CAPITAL GAIN OR A CAPITAL LOSS ARISE FROM THE CGT EVENT? Having established that a CGT event has happened to a CGT asset and that neither the asset nor the event is exempt from CGT or subject to rollover relief, the next step is to calculate the capital gain or capital loss arising from the CGT event. The three main steps in calculating a capital gain or loss are contained in Section 100-45 of the ITAA (1997). These steps are detailed below: Determine the capital proceeds arising from the CGT event;Determine the cost base of the CGT asset; andSubtract the cost base from the capital proceeds. Where the capital proceeds exceed the cost base, the difference is a capital gain (per Item 4). If the capital proceeds are less than the cost base, then one must determine the reduced cost base of the asset (per Item 5). If the reduced cost base exceeds the capital proceeds, then there is a capital loss (per Item 6). If the capital proceeds are less than the cost base, but more than the reduced cost base (ie if the capital proceeds fall between the indexed cost base and the reduced cost base), there is neither a capital gain nor a capital loss (Item 7 of Section 100-45). If the capital proceeds fall between the reduced cost base and the indexed cost base, there is neither a capital gain nor a capital loss. The following rules summarise the possible outcomes: If the capital proceeds fall between the reduced cost base and the indexed cost base, there is neither a capital gain nor a capital loss. In order to determine the amount of capital gain or capital loss, it is important to understand the following terms: capital proceeds;cost base;indexed cost base; andreduced cost base. 6.1 Capital Proceeds Division 116 of the ITAA (1997) deals with the issue of capital proceeds. Section 116-20(1) defines capital proceeds as the sum of the money the taxpayer has received or is entitled to receive, plus the market value of any property the taxpayer received, or is entitled to receive, in respect of a CGT event under the contract of sale. Generally speaking, the capital proceeds will usually be the grossamount of consideration that the taxpayer receives in relation to the disposal of the CGT asset as per the sale contract. However, there will be instances for the purposes of Division 116 where the capital proceeds will not always equate to the actual amount of money received by the taxpayer. According to Section 116-10, there are six modifications (or exceptions) to the rule contained in Section 116-20(1). a. First Modification Rule (The Market Value Substitution Rule) The first modification contained in Section 116-30 (termed the market value substitution rule) provides that if the taxpayer does not receive any capital proceeds from a CGT event, the taxpayer is deemed to have received the market value of the CGT asset at the time of disposal. This first modification applies where: no capital proceeds are received (eg. the taxpayer gives a gift, being, a CGT asset); some or all of the capital proceeds cannot be valued; orthe actual capital proceeds are greater or less than the market value of the asset and the parties to the event were not dealing with each other at arm’s length. Example 3:Mark acquires a vacant block of land in March 1996 for $75,000.On 14 April 2020, Mark sells this block of land to his wife, Tina, for no consideration. The market value of the land on 14 April 2020 was considered to be $125,000.Even though Mark did not receive any capital proceeds in relation to the transfer of the land to Tina, he is deemed to have received $125,000 (ie. the market value of the land as at the date of transfer) in relation to the disposal of the land under the first modification rule contained in Section 116-30 as the two parties are not dealing at arm’s length.Mark has derived a gross capital gain of $50,000 (being $125,000 – $75,000) even though he received no consideration in respect of the sale of the land to Tina. Tina is deemed to have acquired the land on 14 April 2020 for its market value (ie. $125,000). b. Second Modification Rule (The Apportionment Rule) The second modification contained in Section 116-40 (termed the apportionment rule) provides that if the taxpayer receives payment in connection with a transaction that relates to more than one CGT event (eg. sale of land and buildings), capital proceeds from each event need to be apportioned on a reasonable basis. The taxpayer is not required to obtain an independent valuation to justify the apportionment. However, they must take reasonable steps to justify how the apportionment was derived. c. Third Modification Rule (The Non-Receipt Rule) The third modification contained in Section 116-45 (termed the non-receipt rule) provides that the capital proceeds from a CGT event may be reduced if the taxpayer (ie. the seller) does not receive some or all of those proceeds (ie. the unpaid amount). In other words, the capital proceeds are reduced by the amount of the “bad debt”. The reduction in capital proceeds by the unpaid amount is made provided the taxpayer did not do anything to cause the reduction and took all reasonable steps to retrieve the unpaid amount. If the payment is subsequently received, the capital proceeds are subsequently increased (see Section 116-45(2)). d. Fourth Modification Rule (The Repaid Rule) The fourth modification rule contained in Section 116-50 (termed the repaid rule) provides that the capital proceeds from a CGT event may be reduced if the taxpayer (ie. the seller) repays part of the capital proceeds to the purchaser. Repayment may involve giving property back to the purchaser. e. Fifth Modification Rule (The Assumption of Liability Rule) The fifth modification rule contained in Section 116-55 (termed the assumption of liability rule) provides that the capital proceeds from a CGT event may be increased if another entity acquires the CGT asset from the taxpayer and assumes any unpaid liability over the asset. The increase is equal to the amount of the liability the other entity assumes (Section 116-55). Example 4:On 16 May 2020, Joe signs a contract to sell a block of land to Maryanne for $275,000. Joe acquired the block of land in April 1998. Joe initially took out a loan with ANZ Bank to finance the acquisition of the block of land.As at 16 May 2020, Joe still owes ANZ Bank a total of $200,000. As part of the sale agreement, Maryanne gives Joe $75,000 cash and agrees to assume the liability for the outstanding amount of Joe’s loan (ie. $200,000).According to the fifth modification rule contained in Section 116-55, Joe is deemed to have received capital proceeds totalling $275,000 (ie. $75,000 cash plus the assumption of the liability of $200,000). f. Sixth Modification Rule (The Misappropriation Rule) The sixth modification rule contained in Section 116-60 (termed the misappropriation rule) provides that the capital proceeds from a CGT event may be decreased if the taxpayer’s agent or employee misappropriates (whether by theft, embezzlement, larceny or otherwise) all or part of the capital proceeds. 6.2 Cost Base The cost base of an asset is broadly what you pay to acquire a CGT asset. Division 110 deals with cost base and reduced cost base. Section 110-25 states that an asset’s cost base is the sum of the following five (5) elements: (a) the first element – acquisition costs: the money paid, or required to be paid in acquiring the CGT asset plus the market value of any property given, or required to be given (Section 110-25(2)). (b) the second element – incidental costs: incidental costs incurred in acquiring the CGT asset as well as incidental costs incurred in disposing of the asset (Section 110-25(3). Incidental costs covered in Section 110-35 include: stamp duty on the purchase of a property;legal fees on the purchase and/or sale of a property;advertising or marketing costs to find a buyer or seller;real estate agent fees/sales commissions, including the costs of marketing and advertising the property;costs relating to the making of any valuation or apportionment;solicitor’s search fees; andthe cost of purchasing a conveyancing kit. the third element – non-capital ownership costs: The costs of owning an asset consist of any expenditure incurred by a taxpayer to the extent which it is incurred in connection with the continuing ownership of the asset. According to Section 110-25(4), these costs include: interest on money borrowed to acquire the asset;costs of maintaining, repairing and insuring the asset;council rates and land tax;body corporate fees; andinsurance. However, these costs can only be included in the third element of the cost base of an asset provided: the asset to which these costs relate was acquired after 20 August 1991 and;no allowable deduction has been or was able to be claimed for these costs at the time the costs were originally incurred. If the property has been used for income-producing purposes (eg. it is a rental property), then the abovementioned costs are not able to be included in the asset’s cost base, because those costs can be claimed as a deduction at the time they were incurred. In other words, if the taxpayer owns a rental property and generates assessable income, then costs such as interest, rates and repairs and maintenance should have been claimed as an allowable deduction at the time they were incurred. However, in the case where the taxpayer maintains a holiday home and no rental income was derived, then they would not have been entitled to claim a deduction for costs such as interest, rates and repairs and maintenance. In this instance, these costs can be included as part of the third element. The third element does not apply to personal use assets or collectables (Section 108-17 and 108-30). Furthermore, the third element does not qualify for indexation. the fourth element – capital improvement costs: capital expenditure incurred to increase or preserve the asset’s value are included in the fourth element (Section 110-25(5)). Typically, this element includes capital improvements which are not deductible under Section 8-1 or Section 25-10 and are not depreciable under Division 40. Usually, any capital improvement subject to the Division 43 capital works expenditure write-off will be included in the fourth element. The fourth element also includes capital expenditure that relates to installing or moving the asset. Furthermore, it is not necessary that the expenditure be reflected in the state or nature of the asset at the time of the CGT event. (e) the fifth element – title costs: capital expenditure incurred to establish, preserve or defend the title to or a right over the asset (Section 110-25(6)). The Negative Sixth Element – Amounts which Reduce the Cost Base (Div 43) According to Sections 110-45(1A) and 110-50(1A), where a property was acquired on or after 7:30 pm on 13 May 1997, the cost base of the asset is required to be reduced by the accumulated Division 43 claim made each year since the asset was acquired. Where the property was acquired before 7:30 pm on 13 May 1997, the cost base of the asset does not need to be reduced by the Division 43 claim. Division 43 of the ITAA (1997) enables a taxpayer to claim a deduction equivalent to 2.5% per annum of the original construction cost of the building. The Division 43 capital works allowance is equivalent to a write-off over 40 years. The components of the cost base are illustrated in Diagram 2 below. Diagram 2: Determining the Cost Base of an Asset Element 1: Purchase Price Element 3: Ownership Costs Element 5: Title Costs Total Cost Base + + Element 2: Incidental Costs of acquisition and disposal = + Element 4: Enhancement Costs (Capital improvements) + – In the case of an income-producing building (eg. rental property) acquired on or after 13 May 1997, the accumulated 2.5% Division 43 allowance must be taken off if the amount was claimed as an allowable deduction each year Example 5:On 15 November 1995, Paul acquired a rental property for $240,000 which was used exclusively for income-producing purposes. He paid legal fees of $4,000 and stamp duty of $5,200 on the same date. On 14 August 1999, Paul added an inground swimming pool to the house at a cost of $17,500.On 10 May 2020, Paul sold his rental property for $500,000. Sales commission totalled $9,000.Required:Determine the cost base of the rental property with references to the various elements contained in Section 110-25?Furthermore, calculate the cost base and the gross capital gain arising from the sale of the property.Answer:The cost base of the rental property is as follows:$Purchase
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