Downsizer contributions: Tips and traps for SMSFs and their members
In part two of our series on downsizer contributions, I will look at tips and traps SMSF trustees need to be aware of when making these contributions.
Members should note that disposing of their main residence (which is exempt from Centrelink’s asset test) and contributing downsizer contributions to their super fund (which is counted towards Centrelink’s asset test) may adversely impact on their Centrelink entitlements. This is because the Commonwealth government’s age pension provided via Centrelink is assessed against, among other things, an assets and incomes test and those who exceed the applicable thresholds will be denied an old age pension in whole or in part.
A person’s family home is generally not included in that person’s assets test; however, superannuation savings are included once a member reaches pension age. This means that if a member disposes of their main residence and makes a downsizer contribution, the member may either have:
- a reduced age pension, or
- no entitlement to any age pension.
The current asset test thresholds for the Centrelink age pension, at the time of writing, are broadly summarised as follows:
- Single - Full pension $263,250; No pension above $572,000
- Couple - Full pension $394,500; No pension above $860,000
- Single - Full pension $473,750; No pension above $782,500
- Couple - Full pension $605,000; No pension above $1,070,500
- Pension is reduced by $78 p.a. for each $1,000 of pension assets over the full pension threshold
- Full pension thresholds are indexed each 1 July in line with CPI
This aspect significantly reduces the attractiveness of the downsizer provisions for those who would be worse off as a result of a loss to their age pension entitlements. For example, a couple disposing of a dwelling valued at $600,000 to contribute to superannuation when they have $471,000 of assets, and then deciding to rent for a period of time, would be denied an age pension, as their assessable assets for Centrelink purposes would exceed the maximum $1,070,500 threshold in the above table.
The main residence exemption
An understanding of how the capital gains tax (CGT) main residence exemption operates is fundamental for advisers to provide strategic advice on downsizer contributions. As noted above, the dwelling must have been the main residence of the person that satisfied the main residence exemption criteria (in subdivision 118B of the ITAA 1997). In this regard, the ATO notes in Law Companion Ruling LCR 2018/9:
- To make a downsizer contribution the dwelling must have been the individual’s main residence, at some point during the period of ownership, for the purposes of the main residence exemption. Specifically, the capital gain or loss relating to the disposal of the old interest must be wholly or partially disregarded because the property has been treated as their main residence.
It is also important to note that section 292-102 also provides that a downsizer contribution can also be made if the dwelling was a pre-CGT asset (i.e. it was acquired prior to 7.30pm on 19 September 1985 when CGT was first introduced via press release by the then-treasurer Mr Paul Keating). The ATO confirms this in LCR 208/9 as follows:
- If the interest was acquired prior to 20 September 1985, an individual is able to make a downsizer contribution only if they would have been able to claim this main residence exemption had the dwelling been acquired after this date.
To examine an example of Peter who acquired his main residence around 20 years ago for $600,000 (on 1 July 1999) that disposes of it on 30 June 2019 for $1,800,000 when the final 10 years of his ownership interest, it was rented to a third-party tenant, the following CGT implications would broadly apply:
- assuming Peter does not have any capital losses and cannot rely on any other exemption under the main residence provisions such as section 118-145, 50 per cent of the capital gain will be exposed to tax, given his ownership period that the property was used as his main residence is 10 years and 50 per cent of the time it was used to produce assessable income;
- section 118-195 broadly prorates the main residence exemption based on the extent to which the residence was used as the person’s main residence during the entire ownership period (i.e. capital gain x [non-main residence days/days in your ownership period]); and
- since Peter held the asset for more than 12 months, the 50 per cent CGT discount under Division 115 of the ITAA 1997 is then applied to the capital gain in accordance with step 3 of the method statement in section 102-5. Since the asset was acquired prior to 21 September 1999, the indexed cost base method under section 118-36 could also apply, but Peter has elected for the general CGT discount under Division 115 to apply instead. We also, naturally, assume here that the gain is not on revenue account as, broadly, the CGT provisions apply on a secondary basis with a reduction to any capital gain to the extent that it is otherwise assessable on revenue account in accordance with section 118-20.
This results in a net capital gain on disposal of the asset and capital gains tax as follows to Peter:
- Sale proceeds - $1,800,000
- Cost base - $600,000
- Capital gain - $1,200,000
- Less partial main residence exemption section 118-185 (50 per cent) - $600,000
- Less Division 115 50 per cent discount - $300,000
- Net capital gain - $300,000
- Tax at 47 per cent assuming top marginal rate + Medicare - $141,000
As can be seen from the above example, Peter will pay CGT of $141,000 if he disposes of his residence to make a downsizer contribution, and this has to be factored into each client’s particular strategy unless the residence was the person’s main residence for their entire holding period.
If a dwelling is transferred from a “transferor” spouse to a “transferee” spouse for no consideration, the transferor is still, for CGT purposes, deemed to have received the market value of that asset under the market substitution rule in section 116-20 of the ITAA 1997. The following is an extract of this provision:
(1) The capital proceeds from a *CGT event are the total of:
(a) the money you have received, or are entitled to receive, in respect of the event happening; and
(b) the *market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).
Conversely, the “transferee” spouse obtains a cost base equivalent to the market value deemed to have been paid under section 112-20 of the ITAA 1997. The following is an extract of this provision:
(1) The first element of your *cost base and *reduced cost base of a *CGT asset you *acquire from another entity is its *market value (at the time of acquisition) if:
(b) …; or
(c) you did not deal at *arm’s length with the other entity in connection with the acquisition.
In some jurisdictions such as Victoria, a duty concession may be available for the transfer of a person’s principal place of residence where there is, among other things, no consideration provided in relation to that spouse-to-spouse transfer. Thus, where, say, a husband transfers his main residence which is valued at $1 million (which qualifies for the main residence exemption and has been held for more than 10 years) to his wife, the husband is deemed to have received $1 million in capital proceeds under section 116-20 and the wife is deemed to have a cost base of $1 million under section 112-20 for CGT purposes.
The question might therefore be asked: can the husband who is over 65 years make a downsizer contribution?
The ATO has responded to this scenario in LCR 2018/9 as follows (with emphasis added):
- Capital proceeds are defined in the ITAA 1997, and for most cases are the money received, or entitled to be received, from the sale of the interest in the dwelling. The policy intent for the downsizer measure is that an individual source their downsizer contribution from the total proceeds received from the disposal of the ownership interest in the dwelling. It is not intended that an individual be eligible to make a downsizer contribution by entering into a non-arm’s length arrangement to dispose of their ownership interest in the dwelling for less than market value and applying the CGT market value substitution rules so as to be taken to have received the market value of the ownership interest.
- On that basis, where an individual disposes of their ownership interest in a dwelling to a related party on a non-arm’s length basis for less than market value, and the individual or their spouse make downsizer contributions the total value of which exceeds the amount of the sale price specified in the contract, the Commissioner will consider whether Part IVA of the Income Tax Assessment Act 1936 (Part IVA) applies to the arrangement. Part IVA applies to a scheme if a tax benefit has been obtained in connection with the scheme and the main purpose of a person who participated in the scheme, or a part of it, was to enable a taxpayer to obtain that tax benefit.
Note that a proposed amendment to section 292-102(3) is included in the exposure draft of Treasury Laws Amendment (Measures 3 for a later sitting) Bill 2019 that will disregard the market value substitution rule in section 116-30 to the extent it would increase the capital proceeds for the purposes of the downsizer provisions. Broadly, if enacted, this amendment will result in the actual consideration constituting the capital proceeds. This change is proposed to take effect from the date of royal assent of this bill and is therefore not retrospective.
In-kind or in-specie contributions
Downsizer contributions may be able to be made as an in-specie contribution; for example, if the capital proceeds have been used to purchase an asset (such as listed securities and business real property acquired at market value), that asset can be contributed.
Naturally, the prohibition against related-party acquisitions in section 66 of the Superannuation Industry (Supervision) Act 1993 (Cth) must be complied with. As noted, listed securities and business real property acquired at market value are the key exceptions to this prohibition.
Proceeds and borrowings
It is important to note that the downsizer contributions cap is the lesser of $300,000 or the sum of the capital proceeds. Any debt outstanding on a mortgage over the relevant property is not considered for the purpose of determining the capital proceeds.
For example, Peter bought his main residence 14 years ago for $1 million. He then sells it for $1.25 million when his outstanding borrowings are $1 million.
Peter received capital proceeds of $1.25 million. Thus, he can make downsizer contributions of up to $300,000.
Members should also be aware that downsizer contributions are not deductible.
SMSF deed provisions
As the downsizer contribution is a relatively new type of contribution, the SMSF’s deed should have express wording that allows members to make these contributions to the fund, especially as a member over 65 years may not be gainfully employed and in many cases a member may be in excess of 75 years (and prior to 1 July 2018, contributions could not generally be made for members over 75 years under reg 7.04 of the Superannuation Industry (Supervision) Regulations 1994 [Cth]). Additionally, the SMSF deed should provide appropriate mechanisms to resolve what happens when a downsizer contribution is deemed ineligible by the ATO.
Financial product advice
Naturally, since superannuation advice can readily fall within financial product advice, unless you fall within a relevant exemption, non-licensed advisers need to ensure they comply with the relevant Australian financial services licence (AFSL) requirements of the Corporations Act 2001 (Cth). One method of minimising risk here is to recommend your client in writing to obtain advice from an adviser with an AFSL before proceeding with your advice with an appropriate disclaimer.
Daniel Butler, director, DBA Lawyers