Ask Paul: I'm worried I might owe $500k in capital gains tax

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Dear Paul,

I find it difficult to sleep at night because I worry about my future tax obligation as regards my family home. With the proceeds of my divorce settlement, I bought a home for me and my two daughters on Sydney's northern beaches in 2005 for $725,000.

In 2015 I inherited $350,000 from my mother. My daughters had left home, and I was 64, working full-time and thinking of retiring. This option was not looking very attractive due to the sorry state of my superannuation balance.

ask paul clitheroe capital gains tax bill property

Consequently, I came up with the brilliant idea of using my inheritance to put a second storey on my house, which I would move into while renting out the bottom floor.

In 2017, a lovely family moved in. The rental income - which I declare and pay tax on - has given me a wonderful lifestyle that I wouldn't have been able to afford otherwise.

However, I am thinking of selling to move closer to my children. It would appear that I am liable for capital gains tax on the part of my property that has been earning rental income.

This is two-thirds of my house, based on square metres. The valuation of my house in June 2017 with its top storey was $1.5 million. Now, because house prices have gone crazy, it is probably worth around $3 million.

Does this mean I have to pay 50% of $1.5 million ($750,000) less one-third (the part that wasn't rented) to the tax man as CGT when I sell? This would be $500,000. - Denise

Hang on, Denise, I am not so sure the situation is as dire as you are thinking.

I'll spare you my standard lecture on how hard it is going broke paying tax on profits.

If you are losing sleep at night, the last thing you need is me telling you that making money and paying tax is far better than losing money!

There is a lot of money and potential tax liability in play here, so the first thing I want you to do is to talk to a good tax accountant and get all the facts on the table.

Sure, this discussion will cost you hourly fees, which could easily add up, but ensuring the valuation of the house after the work was completed is correct, recognising that you owned the property since 2005, the ratio of rental space to non-rented space and so on are all critical to the final tax liability.

Where I can help you to sleep a little better is that while this indeed will be a CGT issue, CGT has a 50% discount. Without a detailed investigation with a tax adviser, I have no idea if your CGT liability is $1.5 million or not.

But whatever the profit is, it would be subject to a 50% discount. Here, of course, your income is important, as is your ability to add to superannuation in the year of the sale and a lot more!

So don't delay, head straight to a good tax accountant to find out more information.

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Paul Clitheroe AM is founder and editorial adviser of Money magazine. He is one of Australia's leading financial voices, responsible for bringing financial insight to Australians through personal finance books, the Money TV show, and this publication, which he established in 1999. Paul is the chair of the Australian Government Financial Literacy Board and is chairman of InvestSMART Financial Services. He is the chair of Financial Literacy at Macquarie University where he is also a Professor with the School of Business and Economics. Click here to email Paul your money question. Unfortunately Paul cannot respond to questions posted in the comments section. Please view our disclaimer here.