Paying tax when selling a house
Although tax exemption when selling a person’s main residence is usually a routine matter, things can go badly wrong in some quite unexpected ways, writes Chris Ardagna.
The main residence exemption provisions in the capital gains tax regime are usually one of the simpler set of provisions in our tax laws.
If land that you own has a house on it and you live in the house, you will generally be exempt from tax when you sell it.
Yet, the recent case of Gerbic v Commissioner of Taxation [2013] AATA 664 (Gerbic) shows that the main residence exemption can still very easily be messed up.
Gerbic has a simple set of facts. George Gerbic (George) purchased a house for his son, Justin, but to prevent Justin from selling the property on a “whim”, George arranged for the house to be purchased in the name of himself and his son as joint tenants.
Some time later, Justin sold the house – presumably with the permission of George – for a price higher than what was paid for it.
The problem for George was that, as he was not living in the house, it was not his main residence. As George’s half of the proceeds was not exempt from tax, the Australian Taxation Office (ATO) assessed George for tax on the basis that he had made a capital gain from the disposal of his 50 per cent interest in the house.
Justin’s 50 per cent interest in the gain was exempt from tax as the property was his main residence.
George objected to the ATO’s assessment by saying that he had only held his interest on trust for Justin and did not receive anything from the sale. The money had been used to purchase a new property for Justin.
The ATO disallowed the objection. It did not matter that George did not receive the proceeds. He was taxable on 50 per cent of the increase in the value of the property under the CGT provisions.
The matter went before the Administrative Appeals Tribunal (AAT) who held that there was no evidence to substantiate that George held his interest on trust for Justin.
George did not help his case by saying that if he had known about his potential liability, he would have declared a trust in favour of Justin. The clear inference from this was that no trust had, in fact, been created by George in favour of Justin.
The AAT noted that, in any event, it would not matter as, even if a trust had been created, Justin was not “absolutely entitled” to George’s 50 per cent interest in the property and George would have remained taxable as a trustee of the trust.
The CGT provisions provide that where a beneficiary of a trust is “absolutely entitled” to an asset, the asset is treated as being their asset for the purpose of the CGT provisions.
Absent a beneficiary who is absolutely entitled, it is the trustee who makes the capital gain, which in this case was George.
The concept of absolute entitlement occurs, in simple terms, where an asset, although held in the name of one person (the trustee), is owned, for all intents and purposes, by another person (the beneficiary) and the trustee is not able to defeat the beneficiary taking formal legal ownership or dealing with the asset.
‘Absolute entitlement’
The recent decision of the Federal Court in Oswal v Commissioner of Taxation [2013] FCA 745 (‘Oswal’) considered the notion of absolute entitlement.
Oswal demonstrated that ‘absolute entitlement’ requires a consideration of the rights of the trustee as against the beneficiary in relation to the assets of the trust.
In Oswal the Court held that an absolute entitlement to a trust asset cannot arise whilst a trustee has a right to be indemnified out of the assets of the trust for liabilities incurred in acting as trustee.
In Oswal, Edmonds J stated as follows:
‘a trustee’s right to reimbursement and exoneration confers on the trustee, to that extent, a proprietary interest in the trust property; that the trustee cannot be compelled to surrender the trust property to the beneficiaries until the trustee’s claim has been satisfied; that the trustee’s right to exoneration or recoupment takes priority over the rights in or in reference to the assets of beneficiaries; and that the entitlement of the beneficiaries is confined to so much of those assets as is available after the liabilities in question have been discharged or provision has been made for them.’
Edmonds J also noted that a trustee has a right to sell a trust asset in accordance with the various state Trustee Acts, unless expressly excluded by the terms of the trust.
Such a right to sell the trust asset will prevent the beneficiary from being absolutely entitled to the asset as the trustee is able to defeat the beneficiary’s interest in the asset by selling it. This is despite the fact that the beneficiary will be subsequently entitled to the proceeds of the sale.
Oswal suggests an ‘absolute entitlement’ of a beneficiary to a trust asset as against the trustee will only arise in limited circumstances.
In accordance with such principles, the AAT correctly noted that, since George had explained that his reason for putting 50 per cent of the house in his name was to prevent his son from selling it at a “whim”, this meant that the asset was not, for all intents and purposes, owned by Justin.
Justin was restricted from dealing with the interest in the house without the agreement of his father and he, therefore, was not absolutely entitled to George’s 50 per cent interest.
The AAT affirmed that the ATO’s objection decision. The result of this was that George was required to pay tax on 50 per cent of the capital gain from the sale of the house despite not receiving any of the gain. He had to pay tax despite not earning any income.
Does this outcome seem fair or logical? Probably not. But tax law is rarely fair or logical. It cannot be assumed that simply because you do not receive anything from a transaction, that the tax laws will not impose a liability.
What to take away from Gerbic
Gerbic is a reminder that there are tax implications in nearly all transactions. Even transactions that would ordinarily be tax-free, such as the sale of your home, can be subject to tax if messed up.
George’s problem was that he put 50 per cent of the home in his own name but did not live in it. A capital gain was made in relation to his 50 per cent interest in the property but the main residence exemption requirements were not satisfied in relation to that portion of the gain.
The trust argument in Gerbic was never capable of succeeding on the facts.
A major problem, which the AAT did not consider necessary to examine, was that an express trust over real property in Queensland, the state in which the relevant property was located, cannot validly be created unless the declaration of trust is in writing.
It is worth noting that, even if the declaration of trust was in writing, it needed to be stamped for duty or otherwise it would not have been ‘available for use in law or equity’. That is, the trust would not have been enforceable until it was properly stamped with the Office of State Revenue.
Even where an express trust is not validly created, the law can still imply a trust relationship, such as through a constructive or resulting trust. In such cases the requirements mentioned in the previous paragraph will not prevent the valid creation of the trust.
Such trust relationships can be extremely useful in overcoming unintended tax consequences in situations when they can arise. However, the facts in Gerbic simply did not give rise to a constructive or resulting trust.
The worst thing about Gerbic is that the outcome could have been easily avoidable. George could have quite easily achieved the outcome of being able to prevent Justin from selling the house at a “whim” without needing to be a joint tenant. His options included:
Taking a registered mortgage over the property in consideration for lending the money to his son to purchase the house. No mortgage duty would be chargeable.
Making the advance of the purchase monies conditional on the grant of an equitable charge over the property and lodging a caveat over the property.
Either of these options would have, in practical terms, prevented Justin from selling the house without George’s consent. They certainly would have prevented Justin from selling the house on a “whim”.
Some broader lessons from the case include:
Appealing to general notions of fairness, or that you would have done something different if you had known about the tax liability, will not help.
Except where the ATO thinks tax has been avoided, tax law treats a transaction as it is, not how it could have been simply by doing things a little bit differently; and
That a transaction is between family members does not mean that legal advice should not be obtained on the transaction. There are good reasons for such arrangements to be properly documented, not the least of which is the potential for adverse tax consequences.
The proceeds from sale of the house were used by Justin to purchase a new house with his mother. Let’s hope that by the time that house is sold both Justin and his mother are living in it.
Chris Ardagna is the director and Matthew McKee is a senior associate at law and tax services firm Schurgott & Noolan.
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