How the family home can stay in an individual’s name for the purpose of the CGT main residence exemption yet the value can in someone else’s hands. It illustrates the pros and cons of asset divestment to the next generation during the lifetime of the senior generation and how it should and should not be done.
Doris and David Day married in 1975 at the age of 30. Doris was born into a wealthy family and as such never worried about money. David, on the other hand, was born into a hard working blue-collar family and left school at an early age to begin employment with his father as a carpenter.
David’s parents had never owned a property and David made it his goal in life to purchase a house for he and his family to live in.
Doris, in marrying David, went against her parents’ wishes who thought she should marry someone who would be able to financially care for her, as such Doris lost contact with her parents.
Later in 1975 Doris and David purchased a large 3 bedroom home on an ample block size of 800m2 at Ingle Farm in the Northern suburbs of Adelaide for $45,000 using predominantly funds David had saved over his years of working and a loan from the Commonwealth Bank of Australia. The home was purchased as joint tenants.
To cap off a big year for the Days, late in 1975 their only child was born Xanthia, who became known as X.
After such a big year for the Days trouble was brewing.
Doris’ parents convinced Doris that David could never financially cater for both her and X and that she should leave David and return to their mansion in leafy Burnside. Doris agreed and in 1980 she left the family home and took a young X with her.
A year later the divorce was finalised and the property settlement included a transfer of the Ingle Farm house to David, after all he had worked very hard for many years to purchase the house, there was no way he was going to lose it in the divorce.
The Sun would smile upon David again soon after when he bumped into his High School sweetheart Diana who soon after moved into the Ingle Farm property.
In 1982 David and Diana married and, as had been David’s trait, by the end of that year had twins with Diana, they were named Yvonne, who became known as Y and Zoe, who affectionately became known as Z.
David had learnt a thing or two as a result of his divorce and despite finding the love of his life, so in 1985 went to see a lawyer to draft a Will for he and Diana. David was hesitant to transfer the home to anyone and prepared a Will which gave everything to Diana upon his death or if she had failed to survive him them to his children Y and Z.
The lawyer in 1985 did not ask David if he had any other children than Y and Z, after all he had not seen X for 5 years and thought that drafting a Will giving his estate to Y and Z if his partner had died would be enough.
Life was great. Y and Z grew up to be intelligent and strong young women and in 2000, aged 18, they both enrolled in Law at University. Just when things were going great for David tragedy struck again and Diana was killed that year in a car accident on the Gallipoli Underpass on South Road.
David saw a lawyer later that year and despite being told there was no estate to administer, the lawyer asked David about his current Will and after further questioning informed the lawyer about X.
David was told that under his current Will X might mount an Inheritance Claim against his estate (and the house) if he died. This upset David as he had saved, improved and turned his house into his life’s achievement, a legacy he could pass to Y and Z with pride. David asked what he could do gift the house to Y and Z, defeat an inheritance claim by X and be confident he would have a place to live for the rest of his life.
In December 2000 David, now aged 55, executed a transfer of the house and created a legal life interest to himself and the remainder interest to both Y and Z for no value.
The Valuer General’s value of the house is $245,000.
Question 1:
What issues arise as a result of the creation of the life interest in 2000?
The transfer of a legal interest thereby creating the legal life interest is a dutiable event and stamp duty applies. This is very South Australia centric I know, as Stamp Duty is a State based collection the rules and laws that apply vary across the nation, however, it would seem consistent that such an event would be considered dutiable.
Using David’s life tenant factor (I will use the current table – which in South Australia is the 2010-12) at age 55 it is 0.70617.
As the property is valued at $245,000 the value of the life interest is $173,011.
That means the remainder interest is valued at $71,989 and Stamp Duty is payable on that amount – section 60 Stamp Duty Act (SA). That is $1,850 (using today’s calculation) plus a registration fee at the Lands Titles Office.
The creation of the life interest is also considered to be a CGT event A1 – disposal. The house is a pre-CGT asset having been purchased before 20 September 1985 and thus is disregarded. In any event, even if it was a post 1985 purchase this A1 event will still be disregarded as it was David’s principal place of residence.
The creation of the life interest and remainder interest also creates a GCT cost base calculation for both parties, the apportionment rules will apply and each of the life tenant and remainder interest owners will acquire their cost base at this time, the year 2000. That will have consequences much later on.
Question 2:
What issues arise when David dies in 2015?
In 2015 David will be aged 70 and the house is valued at $345,000.
Strictly speaking there is a CGT event C1 for David, that event occurring as a result of the life tenancy coming to an end however, as the life of the legal interest is measured by the life of it’s owner, upon their death coming to a legal conclusion, any CGT is disregarded as a result of section 128-10 of the Tax Act, disregarded as a result of his death.
There is actually no CGT consequence for the remainder owners, the proprietors of the remainder interest do not acquire any asset, their existing interest in the property is simply enlargened. The cost base of the remainder interest owners, who now own the freehold has not altered from the calculation that took place in the year 2000 when their original interest was created, that will of course become relevant when/if they then sell the property.
If the remainder interest owners decide to sell the property at that time CGT event A1 occurs, simple disposal, if they sold for $345,000 and their cost base, calculated in 2000 under the apportionment rule was, for example, $71,898 then their gain will be valued at $273,102 (less sales and associated costs of course).
In this instance there are 2 remainder beneficiaries who would likely split that gain, then on 50% deduction available they would EACH be seen to have made a gain of $68,275.50 which would be taxable at their individual rate.
If they were working at that time and earning say $80,000 then an additional amount of tax payable of $26,672 would apply – pretty hefty (and that’s each).
The calculation becomes even more complicated if Y & Z, or one of them, desired to reside in the property for a number of years after David’s death and then sold the property. It is likely a further calculation and apportionment would occur noting that one of the freehold interest owners used the property/asset as their main residence.
Question 3:
The biggest issues arise however when David, in these circumstances, instead of making things easy and dies, decides he wants to surrender his life interest early and provide the property to Y and Z, what are the consequences that arise in this situation?
David, still aged 70 in 2015, is fit and healthy and upon surrendering his life interest will be caught by further stamp duty event, duty will be payable upon the value of the life interest being transferred again using the relevant life tables.
In this instance the life tenant factor for David is now 0.49457.
The value of the property is now $345,000 hence the value of the life interest being surrender is $170,626 which equates to the payment of $5,658 plus some Lands Titles Office registration fees.
As is common in these circumstances David receives no benefit for the surrender of his life interest. Irrespective, CGT event A1 occurs and the market value substitution rule applies to determine the gain the life tenant makes.
There is still a question as to whether the property, being used for as the main residence of David, the then life tenant owner, still qualifies for a main residence exemption thereby absolving David from any CGT consequences. I believe it will apply, the legal interest to reside in the property (and giving rise to the gain) was used as the main residence and should therefore be exempt.
There will also be additional CGT consequences for the remainder interest owners. Unlike in the situation when David has died and Y and Z acquire the whole of the land without an additional cost base, when David surrenders his interest, usually for no value, the remainder interest owners will have a cost base in 2000 AND a cost base for an additional portion in 2015.
If Y and Z then sell the property, CGT event A1, the CGT consequences for them will be less significant than if David simply died.
Question 4:
Did the creation of the life interest defeat the inheritance claim of X?
In simple terms, yes it did.
On David’s death the life interest ceases and the remainder owners acquire the fee simple in totality.
If David owned nothing else of value then any inheritance claim that may have been brought by X will be nullified.
But didn’t X come from a wealth family, is it likely she would have no current financial need anyway which would hamper any claim she may have issued?
And then there is the anomaly of the notional estate in New South Wales. As the life estate was created in 2000 it is too far back for X to claw back into David’s estate for the purposes of an inheritance claim. If David had died only a few months after its creation then in New South Wales the notional estate possibility continues to exist.
Question 5:
Is there another was of achieving a good end result?
In 1985 when David and Diana drafted their Wills there was an option, subject to David being convinced it was a good idea, for David to transfer his entire interest in the property to Diana (assuming that is in 1985 the transfer of main residence between spouses or domestic partners free of stamp duty existed).
The Diana’s Will would set-up a life interest in the property if she ever pre-deceased David (which is what occurred), and then the remainder interest to Y and Z on David’s death.
There is no CGT event with Diana passing away and the creation of the life interest and remainder interests. The Legal Personal Representative acquires the asset via the Will at the date of her death in 2000 when the property is valued at $245,000 (market rate).
CGT events E6 and E7 do not occur where the Legal Personal Representative transfers the life and remainder interests because of the general exception in Div 128.
The main residence exemption continues to apply in this case to David because he was entitled to reside in the property by virtue of the terms of a Will, so if he surrenders his interest in 2015, despite Stamp Duty being payable, as seen previously, the main residence exemption would negate any gain made by David.
There is a risk of triggering a CGT event if the trustees transfer title other than in accordance with the will, akin to a surrender of life interest situation.
In addition, if the recipient of the life interest pursuant to the Will properly disclaims that interest (during the administration of the estate and prior to being absolutely entitled to it) then no CGT event occurs.
In addition, a greater benefit of dealing with the interest in a Will is to set out additional terms that apply, including when the legal interest concludes. Ordinarily the life interest would conclude upon death however in a Will additional terms could provide for the interest to end when the life interest owner declares that he no longer wishes to reside in the property or by reference to some other event.
Most importantly Taxation Ruling TR 2006/14 covers all of the situations that involve life interests.
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