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Sale of House - Tax Implications

Question:

Brent Wilson is one of your tax-accounting clients. He is a 45 year-old psychiatrist employed by Mindful Pty Ltd (a chain of mental health clinics in Melbourne) 3 days per week, and he also sees private patients in his own consulting room on his remaining time.

Brent sends you the email below following up on a meeting where you discussed the potential tax consequences of the sale of his house, the tax treatment of legal fees incurred in relation to a lawsuit settled in May 2019 and the preparation of his 2018/19 tax return.

From: Brent Wilson

Sent: 

To: Tax Accounting

Subject: Further info – tax issues 2018/19

Attachments: Brent Wilson – Payment Summary 2018/19 Dear Tax Accounting Team,

Thanks for your time in looking into the matters discussed in our recent meeting. Following up, please find below information that may be of assistance in the preparation of my 2018/19 tax return (my 2018/19 payment summary is attached), as well as to address the tax consequences of the sale of my house and also in relation to the legal fees that I paid to my lawyers in May 2019.

My income from Mindful is disclosed in my payment summary. I have also invoiced a total of $15,600 in private patient fees, however on 1 July 2019 my records indicated that $3,600 were not yet received. In relation to my private consultations, my only running expenses are my subscription to “E-Admin” (an electronic booking and payments system) which costs me $1,500 per year, and cleaning which costs me a total of $400 per year. As all my consultation room furniture as well as my computer have already been fully depreciated in previous years, I know I am not able to claim any further depreciation in relation to them.

Here are the details in relation to the sale of my house: I bought it for $400,000 on 1 March 2000 and I’ve lived in it ever since. At that time, I also paid $8,000 in conveyance fees and $20,000 stamp duty in relation to the purchase. Not sure if this would be relevant, however since 1 July 2015 I’ve been running my private consultations at home (I converted one bedroom into a consultation room). The house has a total area of 200 square-meters, and the size of my consultation room is 10 square-meters. I signed the contract of sale on 15 June 2019, and the sale price was

$1,000,000. I have sold my previous residences before and I was never taxed on the profits of the sale, however I am unsure if this would be the case here… Anyway, I googled it and I found some info on this link: https://www.ato.gov.au/general/capital-gains-tax/your-home-and-other-real-estate/your-main-residence/using- your-home-to-produce-income/ - would this be applicable to my case?

Finally, I would like your advice on whether I could claim a deduction for the cost of $25,000 that I paid in legal fees defending myself in a medical negligence lawsuit. The lawsuit was settled on 10 May 2019, and I have paid the fees above on that date.

On a side note – my private health insurance number is 123456789, I’ve held this insurance during the entire year.

I look forward to hearing back from you. Kind regards,

Brent Wilson

  • Applyingthe relevant legislation, identify and discuss the tax implications related to the sale of Brent Wilson’s house, and calculate any net capital gain which may arise thereof. 
  • Applying legislation and case law, advise Brent Wilson on whether he could claim a deduction in relation to the legal fees incurred inMay  

Considering the information provided by Brent Wilson as well as your answer to items 1 and 2 above, prepare Brent Wilson’s statement of taxable income and calculate his final tax liability including Medicare Levy for the year ending 30 June 2019, stating the applicable legislation and case law (note: calculation of private health insurance rebate not required).

Sale of House - Tax Implications

Income Tax Assessment Act, 1997 is the current legislation in Australia governing the provisions in relation to the income tax for the individuals and corporations in the country. Australian Taxation Office, here in after to be referred to as ATO, is an independent statutory body of Government of Australia that regulates the taxation environment in the country. The relevant provisions of the Income Tax Assessment Act, 1997 (ITAA 1997) along with the instructions of ATO shall be followed in this document to recommend the tax treatments to the taxpayer.

Issue:

Identification of tax implications for the sale of Brent Wilson’s house and the treatment of resultant capital gains, if any arising from the sale his house shall be discussed here as per ITAA 1997.

Rules:

As per ITAA 1997, capital gain is the profit arising to the seller of a capital asset from the sale of such capital asset. Such sale must not be part of any ordinary course of business ran by him. In Australia, capital gain was introduced on 20th September, 1985 and thus, all assets acquired after the introduction of capital gain tax in the country, i.e. September 20, 1997 shall be eligible to be taxed for capital gain or capital loss. However, there are certain exceptions to the provisions of capital gain (Evans, Minas and Lim, 2015). Generally the main residence of a tax payer is exempted from capital gain tax provided necessary conditions have been fulfilled by the owner of the house.

According to ATO, the ‘main residence’ is exempt from capital gain tax (CGT) provided the attached conditions as enumerated in the ITAA 1997 have been followed. Sub division 118-B of ITAA 1997 provides the provisions for main residence exemption from capital gain tax (CGT) (Braithwaite, 2017). In order to get the main residence exemption as enumerated in subdivision 118-B of ITAA 1997 from CGT, the property, i.e. residence must have dwelling and it must have been used by the seller for living purpose till the time it was sold. In case there is any vacant block in the property, the exemption of main residence from CGT is not applicable to such vacant block (Collier et. al. 2017). A dwelling is considered as the main residence of the person who has lived in the house by himself alone or along with his family and the address of the house has been used to deliver mail to the person.

Legal Fees Treatment

ATO also provides exception to the above rule of main residence exemption. It provides that though main residence is generally exempt from CGT but the tax payer would not be entitled to the full exemption for the entire gain from the sale of main residence if any part of the dwelling on the main residence was used for producing income to the tax payer (Owner and seller of the property). Thus, in case any part of the dwelling on the main residence was rented out to a business or used for the business or profession of the owner then proportionate gain from the sale of the property shall be assessable and included in the income of the tax payer to calculate taxable income of the tax payer. ATO provides that generally the floor area of the dwelling shall be used as the basis to apportion the portion of gain that is to be assessable and the portion shall be exempt under main residence exemption as per subdivision 118-B of ITAA 1997 (Jones, 2016).


Application:

Brent Wilson brought a house for $400,000 on March 01, 2000 which he was using as his main residence as he was living in the house from the day he brought it to the time right before he sold it. However, Mr Wilson ran his private consultations from the home by using 10 Square meters out of the total floor area of 200 square meters of the main residence. Thus, it is clear, that as provided in ITAA and instructed by the ATO in its official website that the entire capital gain from the sale of his house will not be exempted under main residence exemption as per  the provision of subdivision 118-B of ITAA 1997. The proportion of capital gain shall be assessable that relates to the portion of the residence used for running private consultation of Mr Wilson (Daley and Coates, 2015). This is because this part of the residence was used by Mr Wilson for producing income. Accordingly, the assessable gain and exempted capital gain of Mr Wilson is calculated in the table below.       

 Particulars  

 Amount ($)

 Amount ($)

 Sale proceeds from sale of house  

   1,000,000.00

 Less: Cost base of the house  

 Acquisition cost  

   400,000.00

 Stamp duty  

     20,000.00

 Conveyance fees

       8,000.00

       428,000.00

 Capital gain  

       572,000.00

 Less: Discount (572000 x 50%)

       286,000.00

 Capita gain from sale  

       286,000.00

 Exempted capital gain (2860000 x 190 /200)

       271,700.00

 Assessable gain due to use for producing income (286000 x10/90)

         14,300.00

Note:

  1. Since the house was acquired after 11.45 am (as per the legal time ATC) on September 21, 1999 the indexation method is not applicable for calculating the capital gain from the sale of the house. Hence, CGT discount method (50% discount for individuals) has been used to calculate the assessable gain from sale of the property (Huizinga, Voget and Wagner, 2018).   
  2. The assessable gain has been calculated by taking into consideration 10 square meters of the floor area out of the total of 20 square meters used by Mr Wilson to run his private consultations.

Conclusion:

Taking into consideration the discussion and calculation provided immediately prior to this, it is clear that the entire capital gain of Mr Wilson from sale of the house is not exempted as he used part of the dwelling to produce income from his private consultations. Hence, as per the calculation, the assessable amount of gain that shall be considered for calculating his total taxable income in the income year 2018-19 would be $14,300. The majority portion of the capital gain, i.e. $271,700 shall be exempted under the main residence exemption of subdivision 118-B of ITAA 1997 (Evans and Krever, 2017).

Conclusion

Issue:

Mr Wilson paid legal fees of $25,000 for defending himself against a medical negligence lawsuit. The issue here is to discuss the deductibility of the legal fees incurred by Mr Wilson in calculating his taxable income.

Rules:

Australian Taxation Office (ATO) instructs that a tax payer earning income from running a profession as a medical practitioner, an accountant or any other professional with due qualification, shall be allowed to deduct legal fees for defending a lawsuit against him provided the lawsuit is decided in favour of the professional, i.e. the tax payer. The main aspect of the above ruling is to promote ethical practice in profession (Edmonds, 2015). ATO provides that conducting professional practice with necessary skills, competencies and integrity would be rewarded. Thus, if a professional is wrongly accused of negligence in discharging his duty and a lawsuit is filed against the professional then in order to defend himself such professional would have to take the legal support as necessary. If the lawsuit against the professional quashed by the honourable court and the decision is given in favour of the professional by upholding his professional integrity and competency then, the amount legal fees incurred will be allowed as deduction (King and Case, 2015). This is because such legal fees is not for any breach of professional ethics and code of conduct but to defend the rights of the professional.


Application:

Mr Wilson is a psychiatrist employed by Mindful Pty Ltd. He also runs his private consultations to help patients deal with physiatrist issues. On May 10, 2019 Mr Wilson has paid $25,000 legal fees to his councillor for defending a medial lawsuit against him. As provided in the rules that the deductibility of such legal fees is dependent on the outcome of such cases (Chardon, Freudenberg and Brimble 2016). In case the lawsuit has already been decided and the court has declared that the medical negligence lawsuit against Mr Wilson is not correct and has quashed the lawsuit then the legal fees of $25,000 paid by Wilson shall be allowed as deduction to compute the taxable income of his for the income year 2018-19. As a psychiatrist it is the responsibility of Mr Wilson to provide proper treatment to his patients. In case he has been negligent in discharging his duties as a medical practitioner and the court decides that the medical negligence has been committed by Mr Wilson then the legal fees will not be allowable as deduction (Burkhauser, Hahn and Wilkins, 2015).

Conclusion:

Assuming that medical negligence lawsuit filed against Mr Wilson has been decided by the honourable court in favour of Mr Wilson, the entire legal fees of $25,000 incurred for defending the lawsuit shall be allowed as deduction for computation his taxable income.

Taking into consideration the information provided as to the various income and deductions applicable to Mr Wilson, a statement of taxable income of his shall be prepared in accordance with the guidelines provide by ATO (Saad, 2014). It is important to note that a taxpayer in Australia must file his income tax return periodically to show his taxable income. Preparation of such tax return is made easy with the help of a statement of taxable income.

Statement of Taxable income of Mr Brent Wilson for the income year 2018-19

 Particulars  

 Amount ($)

 Amount ($)

 Gross income received from Mindful Pty Ltd as an employee of the company  

       120,000.00

 Total allowances (Assuming taxable allowances)  

           3,000.00

 Assessable income from employment  

   123,000.00

 Capital gain:  

 Sale proceeds from sale of house  

   1,000,000.00

 Less: Cost base of the house  

 Acquisition cost  

   400,000.00

 Stamp duty  

     20,000.00

 Conveyance fees

       8,000.00

       428,000.00

 Capital gain  

       572,000.00

 Less: Discount (572000 x 50%)

       286,000.00

 Capita gain from sale  

       286,000.00

 Exempted capital gain (2860000 x 190 /200)

       271,700.00

 -

 Assessable gain due to use for producing income (286000 x10/90)

     14,300.00

 Assessable income from profession:  

 Private patient fees received (15600 -3600)

         12,000.00

 Less: Allowable deductions:

 subscription to E-Admin

       1,500.00

 Cleaning cost  

           400.00

 Legal fees for defending a medical negligence lawsuit  

     25,000.00

         26,900.00

Assessable loss from profession

   (14,900.00)

 Taxable income

   122,400.00

Note:

In calculating the taxable income of Mr Brent Wilson it has been assumed that assessable income from profession does not include any other income and the negative income from profession is due to the deduction of legal fees incurred by Mr Wilson for defending a law suit of medical negligence against him. It has been assumed that the law suit has been decided in favour of Mr Wilson thus, such fees has been deduced in computing the assessable income from profession (Wilkins, 2015).   


Taking into consideration the income tax rates for individuals in Australia for the income year 2018-19, provided below, the calculation of income tax liability and Medicare Levy of Mr Brent Wilson have been calculated here.

Taxable income

Tax rate on the income

Up-to $18,200

Nil

$18,201 to $37,000

19c for each $1 over $18,200

$37,001 to $90,000

$3,752 + 32.5c for each $1 over $37,000

$90,001 to $180,000

$30,797 + 37c for each $1 over $90,000

Tax liability and Medicare Levy of Mr Wilson  

 Particulars  

 Amount ($)

 Amount ($)

 Taxable income  

   122,400.00

 Tax liability {30,797 + (122,400 - 90,001) x37%}

         42,784.63

 Medicare Levy is charged at 2% on taxable income (122400 x 2%)

           2,448.00

Thus, income tax x liability of Mr Wilson for the income year 2018-19 is $42,784.63 and Medicare Levy liability is $2,448.00 for the period (Johnson, 2017).

Note:

Individuals in Australia are liable to pay Medicare Levy of 2% for the income year 2018-19. Since no information regarding the reliable child or spouse of Mr Wilson has been provided hence, Medicare Levy has been calculated by imposing a 2% rate on the taxable income of his (Cao et. al. 2015).

References: 

Braithwaite, V., 2017. Taxing democracy: Understanding tax avoidance and evasion. Routledge.

Burkhauser, R.V., Hahn, M.H. and Wilkins, R., 2015. Measuring top incomes using tax record data: A cautionary tale from Australia. The Journal of Economic Inequality, 13(2), pp.181-205.

Cao, L., Hosking, A., Kouparitsas, M., Mullaly, D., Rimmer, X., Shi, Q., Stark, W. and Wende, S., 2015. Understanding the economy-wide efficiency and incidence of major Australian taxes. Canberra: Treasury working paper, 2001.

Chardon, T., Freudenberg, B. and Brimble, M., 2016. Tax literacy in Australia: not knowing your deduction from your offset. Austl. Tax F., 31, p.321.

Collier, P., Glaeser, E., Venables, A., Manwaring, P. and Blake, M., 2017. Land and property taxes for municipal finance. International Growth Center, London.

Council, A., 2017. Strengthening the Medicare Levy to secure the future of the NDIS and other essential universal services. [Online] Available from: https://www.acoss.org.au/wp-content/uploads/2017/09/ACOSS_medicare-levy-FINAL.pdf [Accessed 01 October 2018]

Daley, J. and Coates, B., 2015. Property taxes. Grattan Institute.

Edmonds, R., 2015. Structural tax reform: What should be brought to the table. Austl. Tax F., 30, p.393.

Evans, C., Minas, J. and Lim, Y., 2015. Taxing personal capital gains in Australia: an alternative way forward. Austl. Tax F., 30, p.735. [Online] Available from: https://heinonline.org/HOL/LandingPage?handle=hein.journals/austraxrum30&div=35&id=&page= [Accessed 01 October 2018]

Evans, C. and Krever, R., 2017. Taxing Capital Gains: A Comparative Analysis and Lessons for New Zealand. [Online] Available from: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3085713 [Accessed 01 October 2018]

Huizinga, H., Voget, J. and Wagner, W., 2018. Capital gains taxation and the cost of capital: Evidence from unanticipated cross-border transfers of tax base. Journal of Financial Economics.

Johnson, C., 2017. Government had to reassure Australians about Medicare. Australian Medicine, 29(10), p.17.

Jones, D., 2016. Capital gains tax: The rise of market value?. Taxation in Australia, 51(2), p.67.

King, D. and Case, C., 2015. An international individual income tax comparsion: the united states, australia, and united kingdom. Business Studies Journal, 7(2).

Saad, N., 2014. Tax knowledge, tax complexity and tax compliance: Taxpayers’ view. Procedia-Social and Behavioral Sciences, 109, pp.1069-1075. [Online] Available from: https://www.researchgate.net/profile/Natrah_Saad/publication/270848010_Tax_Knowledge_Tax_Complexity_and_Tax_Compliance_Taxpayers'_View/links/5677536908ae125516ec08a5/Tax-Knowledge-Tax-Complexity-and-Tax-Compliance-Taxpayers-View.pdf [Accessed 01 October 2018]

Wilkins, R., 2015. Measuring income inequality in Australia. Australian Economic Review, 48(1), pp.93-102.

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