The tax consequences of creating a life interest and a right to reside are set out in Taxation Ruling 2006/14.
In respect of life interests, it is worth understanding from the outset that there are two distinct forms of life interests: equitable and legal. An equitable life interest is more common and generally refers to a situation where property is held on trust by a legal personal representative (e.g. the executor of a deceased estate) for the benefit of a life tenant and a remainder owner. A legal life interest refers to property that is not held on trust, but where the legal ownership of the property has actually passed to the life interest owner.
Since an equitable life interest involves property being held on trust, the CGT provisions dealing with trusts have application.
Before delivering any further into this article topic, it is worth setting out a few helpful definitions below:
Original owner = this is the person who owned the asset (original asset) before it passed to a trust (in respect of an equitable interest) or was transferred to the life and remainder owners (in respect of a legal interest).
Life interest = an interest in the income of a trust for the span of someone’s life (in respect of an equitable interest) or an estate for life in real property not held in trust (in respect of a legal interest).
Remainder interest = interest in capital of a trust (in respect of an equitable interest) or an estate in remainder in real property not held in trust (in respect of a legal interest). The remainder interest tends not to provide rights for use or disposal of the property until the life interest ends.
Trustee = legal owner of an asset held on trust for the benefit of life interest and remainder owners (only applicable in respect of an equitable interest).
Market value substitution rule = where there is no consideration obtained from a transaction, this rule may apply to treat capital proceeds of that CGT event as the market value of the asset disposed. The rule may also apply where proceeds received are more or less than market value and the transacting parties failed to deal at arm’s length in respect of the transaction.
Inter vivos arrangement = an arrangement between living persons i.e. not an arrangement made under a will.
The tax consequences which arise from granting a life interest are summarised below. This article firstly considers the tax treatment of equitable life interests before turning to consider the tax treatment of legal life interests. The article then finishes with a brief outline of the tax treatment of a granted right to reside.
Equitable life and remainder interests
On creation of a trust
The creation of equitable life and remainder interests involves the establishment of a trust over an asset held by an original owner.
Consequence for the original owner
The creation of the trust over the original asset triggers CGT event E1. If the trust is inter vivos, there would be a capital gain or loss where the capital proceeds received by the original owner for agreeing to establish a trust over the asset exceed the cost base of the original asset. The market value substitution rule may apply in the calculation of capital proceeds.
However, if the trust is created upon a person’s death according to their will, any capital gain or loss from CGT event E1 is generally disregarded under section 128-10 of the ITAA 1997.
Alternatively, if an asset were transferred to an existing trust by will following the death of the original owner, CGT event E2 would instead occur but, again, the capital gain or loss would generally be disregarded under section 128-10.
Consequence for the trustee
If the trust is inter vivos, the trustee acquires the asset at the time the trust is created (for CGT event E1) or upon transfer (for CGT event E2). The cost base of the acquired asset is the market value of the asset at that point in time.
If the trust is created upon a person’s death according to their will, the trustee acquires the asset at the time of the death. The cost base of the acquired asset is equal to the cost base the asset in the hands of the original owner. However, if the asset was the main residence of the deceased just before they died (and not being used to produce assessable income) the cost base will instead be the market value of the asset at the time of death. The same applies if the asset was acquired by the original owner prior to the introduction of capital gains tax on 20 September 1985.
The trustee may make a capital gain or loss if a CGT event happens to an original asset after it commences being held on trust for life interest and remainder owners. The capital gain would simply be the excess of capital proceeds over the cost base of the asset. However, the capital gain (if any) will generally be disregarded where the dwelling was occupied by an individual who was given rights to occupy the dwelling by will.
Consequence for life interest and remainder owners
The life and remainder owners acquire an interest in the trust asset which is itself a CGT asset. The first element of the cost base of the interest is the consideration provided to acquire the interest.
In respect of a trust created upon death by will, there is generally no consideration and therefore the first element of the cost base is the market value of the interest at the time the interest is acquired.
Life interest or remainder owner disclaims interest
There is no CGT consequence for a life interest or remainder owner if they disclaim their interest effectively.
Deed of arrangement to vary terms of deceased’s will
The beneficiaries of a deceased estate may enter into a deed of arrangement to vary the distribution outcomes under a will. This may involve life interest and remainder owners rejecting their interests under the will and instead taking a share of the residuary of the estate. There is no CGT consequence for the life and remainder owner in this instance provided the requirements set out in Taxation Ruling 2006/14 are satisfied.
Death of person by whose life a life interest is measured
A life interest is generally measured by the life of an individual. If that individual dies, the life interest ends and there will be tax consequences to consider for the life interest owner, the trustee and the remainder owners. Note that the life interest owner is not always the same as the person by whose life a life interest is measured.
Consequences for the life interest owner
CGT event C2 happens if ownership of an intangible asset ends by expiry. Therefore, CGT event C2 happens when the life interest ends. The capital gain is calculated as capital proceeds less the cost base of the interest. The market value substitution rule will not apply where no capital proceeds are received.
If the life interest was measured by the life of the owner of the life interest, any capital loss relevant to CGT event C2 is disregarded.
Consequences for the trustee/remainder owner
The remainder owner may become absolutely entitled to the trust asset on the ending of the life interest. In that case, CGT event E5 would occur.
The trustee makes a capital gain where the market value of the assets held in trust exceed the cost base of those assets at the time the life interest ends. There is an exception from CGT for a trust to which Division 128 applies (the meaning of this phrase is considered later in this article).
The remainder owner makes a capital gain if the market value of the asset/s held in trust (to which they have become absolutely entitled) exceeds the cost base of their interest in trust capital to the extent their interest relates to the asset they have become absolutely entitled to. If the remainder owner did not pay to acquire their interest in trust capital (and did not acquire their interest by assignment) then any capital gain or loss made by the remainder owner is disregarded.
Life interest and remainder owners request the trustee to wind up the trust and distribute assets
The life interest and remainder owners may request that the trustee wind up the trust and transfer the assets.
Transfer of asset to life interest owner
The transfer of the asset to a life interest owner triggers CGT event E6. However, there is a CGT exception for a trust to which Division 128 applies.
The trustee makes a capital gain if the market value of the asset transferred is more than its cost base.
The life interest owner makes a capital gain if the market value of the asset they are transferred is more than the cost base of their life interest. Unlike the outcome for remainder owners, the capital gain to the life interest owner is not disregarded if the life interest was acquired for no consideration.
Importantly, the main residence exemption is not available on the occurrence of CGT event E6 to exempt any capital gain that a life interest owner makes from the ending of their interest. This is the case even where the life interest owner occupied the property as their main residence.
Transfer of asset to remainder owner
The transfer of an asset to a remainder owner triggers CGT event E7. However, there is a CGT exception for a trust to which Division 128 applies.
The trustee makes a capital gain if the market value of the asset transferred is more than the cost base of the asset.
The remainder owner makes a capital gain if the market value of the asset transferred is more than the cost base of the asset. However, any capital gain made by the remainder owner is disregarded if they acquired their remainder owner interest for no expenditure.
Dealings between life interest owners and remainder owners
If a life interest or remainder owner surrenders or releases their interest CGT event A1 happens as there is a change of ownership in the interest. The capital gain is calculated as the capital proceeds from the surrender or release less the cost base of the interest surrendered or released. If the surrender or release is for no capital proceeds or does not occur under arm’s length conditions, the market substitution rule applies to determine the capital proceeds.
Dealings between life interest owners and third parties
If a life interest owner sells or assigns their life interest to a third-party CGT event A1 happens as there is a change in ownership of the interest. The capital gain is calculated as the capital proceeds from the sale or assignment less the cost base of the interest sold or assigned. If the sale or assignment is for no capital proceeds or does not occur under arm’s length conditions, the market substitution rule applies to determine the capital proceeds.
Dealings between remainder owners and third parties
If a remainder owner disposes of a post-CGT acquired interest to a third-party CGT event E8 happens provided the remainder owner did not provide consideration to acquire their interest and did not acquire their interest by assignment. The capital gain is calculated according to a method statement in section 104-95 of the Act. Note that there is an exception from CGT here for a trust to which Division 128 applies.
If the remainder owner paid for their interest, CGT event A1 happens at the time of disposal. The capital gain is calculated as the capital proceeds from the disposal of the interest less the cost base of that interest.
Scope of exemption from CGT for events E5 to E8 in respect of trusts to which Division 128 applies.
CGT event E5 to E8 will not apply in respect of a trust to which Division 128 applies. In essence, the CGT exemption is available where an asset the deceased owned when they became deceased passes to a beneficiary (in administration of the deceased’s estate) and in line with the requirements of section 128-20 of the Act. Note that CGT event E8 does not technically involve an asset passing to a beneficiary. However, the exemption may be available if a beneficiary disposes of their interest in the trust capital as part of the administration of the deceased’s estate.
Legal life and remainder interests
Granting an interest inter vivos
If the owner of real property disposes of a legal life interest to another person, CGT event A1 happens. The capital gain made by the original owner is the capital proceeds from the disposal less the relevant portion of the cost base of the original asset which relates to the life interest. The market value substitution rule may apply in the calculation of capital proceeds. In this way, the grant of a legal life interest is best understood as a partial disposal of the real property over which the interest is being granted.
If the owner of real property disposes of a legal remainder interest to another person, CGT event A1 also happens in the same way as described above.
The life interest and remainder owners acquire their respective interests at the time CGT event A1 happens to the original owner. If the interest is acquired for no consideration or where the parties do not deal at arm’s length, the market value of the interest (at the time the interest is acquired) will be the first element of the cost base of the interest.
Granting an interest under the will of a deceased person
The deceased may give a legal life and remainder interest in real property owned at death. In this circumstance, the legal personal representative (e.g. executor) of the will is deemed to have acquired the real property at the deceased’s date of death. The cost base of the acquired property is determined under the rules in section 128-15(4) of the Act.
The transfer of the legal life and remainder interests to beneficiaries in accordance with the deceased’s will is exempt from CGT. However, any subsequent capital gain that the life interest or remainder owner makes on the ending of their trust interest will not be CGT exempt. The cost base of the acquired interest by the life interest and remainder owners is based on a reasonable apportionment of the cost base of the asset in the hands of the legal personal representative.
Disclaimer of legal life or remainder interest
If a legal life interest or remainder owner disclaims their interest effectively there is no CGT event that happens. The life interest and / or remainder owners are treated as though they never obtained an interest.
Death of life interest owner
If a life interest owner becomes deceased, CGT event C1 occurs. However, any capital gain or loss to the life interest owner is generally disregarded under section 128-10.
The death of the life interest owner has no CGT impact on the remainder owner. This is because the remainder owner does not acquire any asset from the life interest owner per se. Rather, the existing interest of the remainder owner simply becomes larger. Note that the remainder owner may not inherit the cost base of the deceased life interest owner’s interest. This may result in a increased capital gains which are assessed to the remainder owner on the realisation of their interest.
Dealings between the life interest and remainder owners
If the legal life interest or remainder interest is surrendered or released, CGT event A1 happens. The market value substitution rule may apply in the calculation of capital proceeds.
Mere right to occupy
A mere right of occupation or a ‘right to reside’ is different from a legal or equitable life interest. The grant of a right to reside triggers CGT event D1.
Tax outcome for the grantor
The grantor of the right will make a capital gain under CGT event D1 where the capital proceeds from granting the right exceed the incidental costs related to providing the grant (e.g. costs of lawyers, accountant or valuer providing services and advice in relation to the grant). If the grantor does not receive consideration for the right, the market value substitution rule does not apply. However, if the grantor receives some consideration for granting the right and the parties are not acting at arm’s length, the market value substitution rule will apply based on the market value of the granted right.
The capital gain or loss the grantor makes from granting the right to reside may not be disregarded under the main residence exemption, even if the relevant dwelling is or was the main residence of the grantor.
Tax outcomes for the grantee
The right to reside is a CGT asset which the grantee acquires when the right is granted. The cost base of the acquired right is the consideration paid to acquire it. If no consideration is provided, the first element of the cost base of the acquired right is the market value of the right at the time it is acquired. The cost base market value rule also applies where some consideration is provided but where parties did not act at arm’s length.
Note that the right to occupy a dwelling counts as an ownership interest in a dwelling for the purposes of entitlement to the main residence exemption. Therefore, any capital gain or loss the grantee of the right to reside makes in relation to the right (e.g. selling the right) may be disregarded under the main residence exemption if the requirements for that exemption set-out in Subdivision 118-B of the Act are satisfied.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.