Using your home to produce income - effect on main residence exemption

Dated: March 2004

A question frequently asked is how the use of a home for income-producing purposes affects an individual’s entitlement to a main residence exemption. A useful summary has been provided below.

General

This summary looks at where you use part of your home for income-producing purposes while living in it. It does not deal with where you move out of your home and then use all of it for income-producing purposes (for example, by renting it to tenants).

You may not be entitled to a full main residence exemption if you:

• acquired your home on or after 20 September 1985
• used part of it to produce income at some time during the period you owned it, and
• satisfy the interest deductibility test.

You satisfy the interest deductibility test if you would be allowed a deduction for interest had you incurred it on money borrowed to acquire your home. This is explained in more detail below.

If you sell your home and you satisfy the interest deductibility test, you must work out whether you have made a capital gain or loss from that part of your home used to produce income in a way that satisfies the interest deductibility test.

Special rules apply to work out the amount of your capital gain or loss if you first use a home to produce income in a way that satisfies the interest deductibility test after 20 August 1996. (These rules may also apply if you move out of your home and use it for income-producing purposes but, as stated above, this summary does not deal with that situation.)

Interest deductibility test

You would satisfy the interest deductibility test if you run a business or professional practice from your home, and:

• part of your home is set aside exclusively as a place of business and is clearly identifiable as such, and
• that part of the home is not readily adaptable for private use, for example, a doctor’s surgery located within a doctor’s home.

You would also satisfy the interest deductibility test if you rent to a tenant, on an arm’s length basis, an identified part of your home with access to general living areas (see Taxation Ruling IT 2167).

You would not satisfy the interest deductibility test if, for convenience, you use a home study to undertake work usually done at your place of work. Similarly, you would not satisfy the interest deductibility test if you do paid child-minding at home (unless a special part of the home was set aside exclusively for that purpose).

The interest deductibility test may be satisfied even if you didn't borrow money to acquire your home – you must apply it on the assumption that you did borrow money to acquire it. The test is also satisfied if you did borrow money and were entitled to claim a deduction for the interest, even if you did not actually claim the deduction.

Working out your capital gain or loss that is not exempt

The proportion of any capital gain or loss that is taken into account for tax purposes is an amount that is reasonable having regard to the extent that, had you borrowed money to acquire your home, you would be entitled to a deduction for interest. In most cases this would reflect the proportion of the floor area of the home that is set aside to produce income and the period it is so used.

Example: Running a business in part of a home for part of the period of ownership Ruth bought her home under a contract that was settled on 1 January 1999. She sold it under a contract that was entered into on 1 November 2002 and settled on 31 December 2002. It was her main residence for the entire four years. From the time she bought it until 31 December 2001, Ruth used part of the home to operate her photographic business. The rooms were modified for that purpose and were no longer suitable for private and domestic use. They represented 25% of the total floor area of the home. When she sold the home, Ruth made a capital gain of $8,000. The following proportion of the gain is taxable: Capital gain     ($8,000) X percentage of floor area not used as main residence (25%) X percentage of period of ownership that that part of the home was not used as main residence (75%) = taxable proportion     $1,500 As Ruth entered into the contract to acquire the home before 11.45am (by legal time in the ACT) on 21 September 1999 and entered into the contract to sell it after that time, and held it for at least 12 months, she can use either the indexation or discount method to calculate her capital gain. The indexation method doesn't apply to assets acquired after 11.45 am on 21 September 1999. The ‘home first used to produce income’ rule (explained below) does not apply because Ruth used the home to produce income from the date she purchased it.

Home first used to produce income after 20 August 1996

If you start using your home to produce income (in a way that would satisfy the interest deductibility test) for the first time after 20 August 1996, a special rule affects the way you work out your capital gain or loss.

In this case, you are taken to have acquired your home at its market value at the time it is first used to produce income if all of the following apply:

• you acquired the home on or after 20 September 1985
• you first used it to produce income after 20 August 1996
• you would get only a part exemption because the home was used to produce assessable income during the period you owned it, and
• you would have been entitled to a full exemption if you had sold the home immediately before you first used it to produce income.

If this rule applies, you are taken to have acquired the home for its market value when you first start using it for income-producing purposes. The effect of this rule applying is that the period before the home is first used by you to produce income is not taken into account in working out the amount of any capital gain or loss. The extent of the exemption for the period after the home was first used to produce income depends on the proportion of the home used to produce income.

Example: Home first used to produce income after 20 August 1996 Louise purchased a home in December 1991 for $200,000. The home was her main residence. On 1 November 2001 she started to use 50% of the home for a consultancy business. At that time the market value of the house was $220,000. She decided to sell the property in August 2002 for $250,000. The capital gain is 50% of the proceeds less the cost base. Percentage of use 50% X (proceeds – cost base) ($250,000 – $220,000) = capital gain $15,000 Louise is taken to have acquired the property on 1 November 2001 at a cost of $220,000. Because she is taken to have acquired it at this time, Louise is taken to have owned it for less than 12 months and therefore cannot apply the indexation or discount method to calculate her capital gain.