Death and the Main Residence Exemption

The capital gains tax ('CGT') main residence exemption is a crucial form of relief for homeowners, as it can mean that the proceeds from the sale of their home are tax-free.

Special rules apply where a homeowner dies and it is another person who sells the property (e.g. the legal personal representatives ('LPRs') of their estate or their beneficiaries).

Understanding how these special main residence rules operate is important for tax-effective estate planning and to help LPRs and beneficiaries avoid unexpected tax liabilities.

The Special Rules

A dwelling owned by a deceased person just before their death can be sold at one of three levels:

1. by the LPR (i.e. executor/administrator) of the deceased estate;
2. by the beneficiary to whom the dwelling passes (after it has been distributed to them by the estate); or
3. by the trustee of a testamentary trust (if the will provides that the dwelling is to be held on the terms of a testamentary trust).

Section 118-195 of the Income Tax Assessment Act 1997 (Cth) ('ITAA97') contains the key rules for determining whether the sale of a dwelling by an LPR or beneficiary qualifies for the main residence exemption.

These rules do not specifically state that they operate where a trustee of a testamentary trust sells a dwelling. While the Commissioner does extend CGT relief to trustees of testamentary trusts in other contexts where that relief would otherwise appear to not be available, it is a live issue as to whether that concessionary treatment extends to the main residence exemption.

Where the requirements of section 118-195 are satisfied, the full main residence exemption applies (i.e. the entire capital gain arising from the sale is disregarded). If the full main residence exemption does not apply, a partial main residence exemption may be available.

Relevant Considerations

Whether or not an individual beneficiary or the LPR of a deceased estate is entitled to the full main residence exemption under section 118-195 when they sell the property depends on various factors, including:

1. whether the property was acquired by the deceased prior to 20 September 1985 (i.e. pre-CGT) or on or after 20 September 1985 (i.e. post-CGT) (i.e. whether the property was a pre-CGT asset or post-CGT asset in the hands of the deceased);
2. whether the deceased used the property as their home immediately prior to their death;
3. if the property was not their home immediately prior to their death (including if the deceased lived at a nursing home), whether
   1. the property was rented out; and
   2. if it was rented out, the length of time that it was rented out (i.e. six years or less or more than six years);
4. whether the property is sold (and settled) within two years of the deceased's death;
5. whether the property is less than two hectares in size;
6. whether the deceased was an 'excluded foreign resident' (i.e. a foreign resident for tax purposes for a continuous period of more than six years) just before they died; and
7. where the beneficiary sells the property, whether the beneficiary is an excluded foreign resident just before the property is sold.

The Basic Case

As can be seen from the above, there are many variables that will affect the outcome.

For the sake of simplicity, we will take a look at the basic case where:

1. the deceased used the property as their home immediately prior to their death;
2. the property is less than two hectares in size; and
3. the deceased and the beneficiary to whom the property passes are residents of Australia for tax purposes at all relevant times.

The circumstances in which the main residence exemption will apply in this scenario will depend on whether the relevant property was a pre-CGT asset or post-CGT asset in the hands of the deceased just before they died.

Pre-CGT Asset

Where the property was a pre-CGT asset in the hands of the deceased, an LPR or beneficiary will be entitled to the full main residence exemption on any capital gain arising from the sale of the property is either:

1. the property is sold (and settled) within two years of the deceased's death (or within a longer period allowed by the Commissioner); or
2. for the period from the deceased's death to when the property is sold, the property was the main residence of one or more of:
   1. the deceased's spouse (except a spouse who was living permanently separate and apart from the deceased);
   2. an individual who had a right to occupy the property under the deceased's will; or
   3. if the property is sold by the beneficiary - that beneficiary.

Significantly, the main residence exemption applies to pre-CGT property regardless of whether or not the property was the deceased's main residence just before they died. This means that the main residence exemption can potentially apply to investment properties and holiday homes owned by a deceased person where they acquired that property prior to 20 September 1985.

Post-CGT Asset

Where the property was a post-CGT asset in the hands of the deceased, an LPR or beneficiary will be entitled to the full main residence exemption on any capital gain arising from the sale of the property if:

1. the property was the deceased's main residence just before their death (regardless of whether or not they previously rented out the property); and
2. either of the conditions set out at above for pre-CGT assets are satisfied, i.e. the property is sold within two years (or within a longer period allowed by the Commissioner) or the property was the main residence of one or more of the persons specified above from the deceased's death to when the property is sold.

Property Acquired as a Co-Owner

When determining whether a property was a pre-CGT property or post-CGT property in the deceased's hands, care must be taken where the deceased originally acquired the property as a co-owner (either as a joint tenant or as a tenant-in-common) with someone else (e.g. their spouse) prior to 20 September 1985.

In this circumstance, if that other person died on or after 20 September 1985, the interest that the deceased acquired (or, in the case of a joint tenancy, is deemed to acquire for CGT purposes) upon that person's death will be a post-CGT asset. The deceased will then effectively be treated as owning two separate assets for CGT purposes: the interest that they always owned (which will remain a pre-CGT asset in their hands) and the interest that they subsequently acquired (which will be a post-CGT asset in their hands). The main residence criteria set out above for pre-CGT assets and post-CGT assets will then need to be applied separately for each relevant interest.

The Two-Year Requirement

As flagged above, the Commissioner has the discretion to extend the two-year period for the sale of the property.

PCG 2019/5 sets out a safe harbour compliance approach under which a taxpayer is allowed to manage their affairs as though the discretion has been exercised to provide an additional period of up to 18-months for the property to be sold (and settled).

In order to qualify for the safe harbour, the LPR or beneficiary needs to satisfy certain conditions as specified in PCG 2019/5.

If an LPR or beneficiary seeks to rely on the safe harbour, they should maintain all records necessary to support their claim that they are eligible for the safe harbour as they will need to be produced in the event of an ATO compliance check.

If an LPR or beneficiary is ineligible for the safe harbour (e.g. because an extension of more than 18 months is required or because they do not meet one or more of the other conditions to access it), a private ruling application will need to be made to the Commissioner requesting that the discretion be exercised.

Generally, a private ruling application will only be entertained after the property is sold and settlement has taken place.

Any private ruling application to the Commissioner will need to be carefully drafted in view of the circumstances and by reference to PCG 2019/5.

Conclusion

The application of the main residence exemption on death is complex. Various factors are relevant to whether or not the exemption applies, including whether the property was a pre-CGT asset or post-CGT asset in the deceased’s hands immediately before their death and whether the property has been sold (and settled) within two-years of the deceased’s date of death. There is also uncertainty in terms of whether the exemption is available to trustees of testamentary trusts.

If the two-year period is exceeded, it is possible that the safe harbour in PCG 2019/5 will apply to allow an LPR or beneficiary an additional period of up to 18 months to sell the property. Guidance should be obtained to confirm whether the safe harbour applies and, if so, to document the reasons (supported by evidence) in the event of an ATO compliance check.

If the safe harbour is not available, it may be appropriate to make a private ruling application to the Commissioner for the exercise of the Commissioner’s discretion to extend the two-year period.

As mentioned above, if the requirements for the full main residence exemption in section 118-195 of the ITAA97 are not satisfied, all is not lost as it is possible that the partial main residence exemption will apply depending on the circumstances.

Given the amount of wealth that is typically tied up in the family home, it is important that that the main residence exemption is considered as part of the estate planning process as well as by an LPR, beneficiary or trustee of a testamentary trust following the death of a homeowner. If the rules are not considered, it is possible that the LPR, beneficiary or trustee of a testamentary trust may be hit with a hefty (and potentially avoidable) tax bill when they eventually come to sell the property.

This article in no way constitutes legal advice. It is general in nature and is the opinion of the author only. You should seek legal advice tailored to your individual circumstances before acting on anything related to this article.