plan4cgt - Primary residence - rental exception/other comments

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Higher level - misconceptions; what is a primary residence

Level above - Apportionments - period;usage;size;joint owners

Also at this level - Period  apportionment concession

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This page -Usage apportionment concession;  land apportionment concession; trade; repairs and ordinarily resident.

 

 

Primary residences, exceptions to general apportionment propositions

Usage apportionment exception, (or concession)

Our term ‘usage apportionment’ exception is a bit of a misnomer in that the concession operates along the lines of a period apportionment. In effect, this concession, as you will see, allows you to rent out your primary residence under very restrictive circumstances and you will still be regarded as having used that residence for domestic use, (as opposed to trade), during that period.

The general rule is that you, or your spouse, have to occupy, (or have occupied), a residence as the main residence mainly for domestic purposes for the primary residence exclusion to apply at all. Where you use a portion of that residence for the purposes of trade, an apportionment will arise to the extent that the residence is applied for trade purposes. In this regard, if you use a portion of a residence as a home office, rent it out, and so on, the usage apportionment applies, (provided the residence was still mainly used for domestic purposes).

Numerous examples of the usage apportionment are available for review.

This part deals with the specific exception/concession to this concept insofar as renting out is concerned -

The exception

The owner/special trust beneficiary, or spouse, will still be treated as having used that residence for domestic purposes during any continuous period of absence therefrom (for up to five years) while the residence was being let, if all of the following conditions apply-

  • that person/beneficiary or spouse resided in that residence as a primary residence for a continuous period of one year prior to and after the period of absence.
  • no other residence was treated as a primary residence of that person/special trust beneficiary during the period of absence.
  • that person/beneficiary or spouse was either temporarily absent from South Africa or employed/engaged in carrying on business in South Africa at a place further than 250km from that residence.

SARS’ Comprehensive Guide to Capital Gains Tax makes the point that the purpose of this concession is twofold. Namely

    1. To allow a qualfying person to rent that residence out without disqualifying that period of ownership as non-residential usage, and

    2. To provide a safe harbour for that qualifying person to be temporarily absent from that primary residence without affecting the ordinary residence status of that residence.

We’ll accept this!

We do not believe that there is any great need to analyse the three requirements that give rise to the exception as they are self- explanatory. However, we would like to point out a number of things.

The actual wording in the introduction of this exception is ambiguous to the extreme. It appears as if the period of absence should not exceed five years, however, upon reading SARS’ Comprehensive Guide, it seems like it is the rental period that should not exceed five years. This makes a great deal of difference! First we would like to quote from page 115 of SARS’ draft “Comprehensive guide to Capital Gains Tax.”(The emphasis is our emphasis.)

“the primary residence will not be allowed to be let for more than five years. If a primary residence were to be let for more than five years, the full period would not be treated as residential usage.....”

Then we have the following comment, it concerns itself with the position of a person who was temporarily absent from South Africa as at 1 October 2001.

“Provided that the person has resided in the residence for more than a year before letting the residence, and the letting period before and after 1 October 2001 does not exceed five years , the person will have met the relevant requirements.”

One last point here - The paragraph heading in the CGT legislation is called “Rental periods”.      

These comments beg the following question -

If you are absent for more than five years, but only let out the residence for five years, do you still qualify?

If SARS’ comments are anything to go by, it looks like it. In any event there is no real need to dwell on this until it comes up, and it wont happen often.

Some writers on the subject think this entire concession/exception is hardly relevant at all. Take a look at the following comment, (we disagree most wholeheartedly!)  

    “Since a primary residence can be constituted through a “right of occupation” of a property...most persons who are away from their usual home for an extended period on business are likely to obtain a “right of occupation” in some form or other at that business destination. This would then become a primary residence as defined and the concession would fall away. In practice, the concession seems to be of use mostly where individuals have rented their properties while on extended backpacking holidays”.

This is an extract of Ernst & Young - Practical guide to capital gains tax 2003, on page 84”.

With all due respect, this comment ignores the fact that to be a primary residence, you or your spouse must be, (or must have been), ordinarily resident in that residence as your main residence. The mere fact that you may be seconded overseas for an extensive period should not necessarily imply that that luxury accomodation you rent at your business destination is your primary residence. What makes it your main residence and what makes you ordinarily resident there are the facts to be considered. The concept of ordinary residence is a question of fact.

Land apportionment exception/concession

The rule is that only two hectares of land on which the primary residence is situated may qualify for the primary residence exclusion. For this reason we get what we refer to as size apportionments.There are no exceptions to this rule.

In certain circumstances the disposal of unconsolidated adjacent land, (up to two hectares in total), may also be counted into the primary residence exclusion. In order for this concession to apply the following conditions must be complied with -

  • it must be used mainly for domestic or private purposes together with the primary residence and
  • it must be disposed of at the same time and to the same person as that residence.

This is fairly self-explanatory, but nevertheless things can go wrong - particularly in terms of the timing rules. These timimg rules don’t look too bad but they can be an absolute nightmare! Here is an example of what can go wrong, timing rules-wise.

Mr Manuel offers to buy your primary residence, and he does so via an unconditional purchase. At the same time he offers to buy the adjacent land, but this is subject to a suspensive condition-any suspensive condition. For example, that the servitude is set aside; that the soil bears certain characteristics; that a rezoning application be approved, and so on.

Even if both deals are finalised, (irrespective of the date of registration - which is irrelevant), the disposals are subject to different timing rules. The timing of the disposal relating to the unconditional offer is when the contract is concluded, (upon the acceptance of the offer by yourself). The timing of the conditional offer is when the condition is met. The point here is to make yourself aware of the timing rules, and if in doubt, consult a professional.

 

The trade concept

This concept is of particular relevance insofar as the usage apportionment is concerned. The floor space dedicated to the earning of rental income will not, apart from the specific instance outlined above, be taken into account in the determination of the primary residence exclusion. But what else will not qualify?

    Provisions of the Income Tax Act

    The general deduction provisions of the Income tax Act allow for the deduction of expenditure, (not of a capital nature), that is incurred in the production of income, provided that it is incurred in the course of trade. The earning of rental income is specifically included in the carrying on of a trade. As such, costs associated with the space in a residence that is allocated for business purposes may be claimed as a tax deduction.

    SARS have persistently resisted the creation of tax losses from renting out homes, in particular, holiday homes. Their basic counter argument is that the taxpayer has an ulterior motive, (to get SARS to partially finance the costs associated with that house, (interest costs and so on)). However, SARS does have a tendency to allow the deduction of current expenditure, (interest, rates, repairs and so on), to the extent of income earned, thereby allowing the taxpayer to break-even from an income tax perxpective.

    Many taxpayers carry on a business from home and to this end deduct a proportion of interest costs, rentals paid, rates and so on against income earned. These are perfectly legitimate deductions as they arise in the course of trade. When you dispose of your home SARS should be well aware that part of your home does not qualify for the primary residence exclusion. So watch out!

    Some people dedicate a portion of their home as a home office. The deduction of home office expenditure against employment income, (which falls within the trade concept),  has been severely curtailed.

    It is quite likely that the tax saving generated by claiming home associated business costs against normal income would outweigh the CGT liability resulting from having a smaller primary residence exclusion. However, beware of the fact that if more than fifty percent of your residence is dedicated to trade, the exclusion will not apply at all.

Repairs, (and other ongoing costs)

There are certain specific categories of expenditure that are included in the base cost of an asset. The cost of acquistion of an asset clearly qualifies as do the cost of improvements. (In the latter case there is a restriction in that improvements will only qualify if they are still reflected in the asset at the time of disposal.)

Running costs incurred on residences can be substantial. Such costs would normally include bond interest, rates, insurance and repairs and maintenance. These costs will almost invariably not qualify for the inclusion in the base cost of a residence.

From an income tax perspective there can be a fine line between repairs and improvements. There have been a great many tax cases on this and certain principles can be drawn, but the matter is not at all clear. Up to this point, in South Africa in any event, taxpayers have sought to classify expenditure as repairs as such a classification could result in an income tax deduction, (where the asset concerned is employed in the production of income). From the point of view of running a business this perspective will not change.

However, from a private person’s perspective, the classification of expenditure on residences as improvements should be the major focus. If major expenditure is considered, it would be advisable to familiarise yourself with the distinction between repairs and improvements.

Expect many more repair vs. improvements disputes!

Ordinarily resident

The importance of this concept is related to the fact that there will be what we refer to as a ‘period apportionment’ in respect of the gain/loss into that that qualifies for the primary residence exclusion and into that that doesn’t.

The “ordinarily resident” concept has been considered in South African tax cases principally in relation to whether or not you are considered to be ordinarily resident in South Africa. It has never been considered in the light of whether, given that you are resident in South Africa, you are resident in this residence or that residence. There could be a subtle difference in approach!

SARS’ Comprhensive Guide to Capital Gains Tax refers to interpretation note 3 in this regard. However, the thrust of this interpretation note concentrates on the ordinarily resident in South Africa situation.

 The following considerations are important-

  • The country the which the person would naturally and as a matter of course return form his wanderings.
  • His usual or principle residence or real home.
  • Living in a place of some degree of continuity, apart from temporary absences.
  • Part of a person’s ordinary regular course of life to live in a place with a degree of permanence, (not temporary or casual).
  • The question as to whether or not you are ordinarily resident is one of degree, you have to look at the taxpayer’s mode of life beyond the period in question.

There are no hard and fast rules! Let’s have a look at an example in the Comprehensive Guide.

Thomas is transferred from East London to Durban. He retains his East London home that he has had for 20 years and allows his son, who is finishing his studies to stay there, rent-free. In the meantime they, (Thomas and his wife), rent a residence in Durban, not only that, they also spend their holidays in East London and stay in the home. Thomas has only two years to go before he retires after which he itends returning to East London.  

Given these facts, SARS’ conclusion is that “...he would probably be considered to be ordinarily resident there”. It is not hard to see why after all they-

  • Hardly spent any time in Durban;
  • They moved back.
  • They knew they would be obligated to stay in Durban for a maximum of two years.
  • There son continued staying in the residence.
  • They maintained contact, by way of going back there for their holidays. (Some holidays they have!)
  • They had the house for twenty years.

Given the above Thomas would only “probably” be considered to be ordinarily resident! There seems to be very little doubt about it!

But the example goes on  - “Should Thomas have been absent from his home for, say, 15 years, it would be far more difficult for him to argue that he was ordinarily resident in that home.”

Well!

Here is a synopsis of another example -

Ursula and Victor stay in residence in Jhb. Victor has a residence in Plett that he owned nad lived in for three years before meeting Ursula. After they got married he moved into her home. Both work in Jhb and spend their annual leave in Plett. The remainder of the time the Plett home is let out and seven years later it is sold.

Victor is not considered to be ordinary resident in the Plett home. He has not returned to Plett other than for holidays and he is essentially resident in Jhb where he is permanently located.

This seems to be fair enough considering the facts, but what if there were some more facts-

  • Ursula is the main breadwinner and she was close to selling her business and retiring. They fully intended moving to Plett, however, their move was delayed due to a potentially lucrative contract, but things went wrong and she was sued. They had to sell the Plett home so as to meet the legal fees in defending the action. or
  • Ursula had a carrer path in IT. They agreed  that they would stay in the Jhb home for a period of time until she made a name for herself, after which she could commute to Jhb from time-to-time and handle the rest of the work remotely, (in  Plett). During this time Victor looked after the household and brought up the kids and even enrolled them in a school in Knysna. However, things did not turn out as planned and they were forced to sell their home in Plett, for whatever reason.

Is it not possible that Ursula has a primary residence in Jhb and Victor one in Plett?

We have said this many times on the site, ‘expect a lot of disputes on this one’! Where would Victor return to after his wanderings? What is his real home? And is this not, in his mind anyway, a temporary absence?