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Facts to Consider When Disposing of a Primary Residence that was Partially Used for Business Purpose

22 August 2013   (0 Comments)
Posted by: Author: Doria Cucciolillo
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Author: Doria Cucciolillo (TheSAIT)

Background 

In the event that a person disposes of an asset, it usually triggers capital gains tax (CGT) implications. However, a portion of the capital gain that arises may be excluded if a natural person or a special trust disposes of a primary residence. The focus of this article is to outline the instances where these exclusions are applicable as well as the apportionment thereof if a part of the residence was used for business purposes. 

The meaning of primary residence

In order to qualify for the primary residence exclusion, the residence (whether it is a structure, boat, caravan or mobile home) must meet the definition of a "primary residence” as set out in paragraph 44 of the Eighth Schedule to the Income Tax Act. Therefore, a natural person or a special trust needs to hold an interest in the residence, e.g. a real or statutory right or the right to use or occupy such property. In addition, the natural person or beneficiary of a special trust must have resided in this residence and regarded it as his or her main residence for a certain period. Finally, the residence will only qualify as a "primary residence” if it was used mainly (therefore, more than fifty per cent) for domestic purposes. The latter implies that no primary residence exclusion is available if, for example, a business owner or professional person uses more than fifty per cent of his or her primary residence for business (non-residential) purposes. 

Primary residence exclusions simplified

Once it is established that the property qualifies as a "primary residence”, one needs to determine if the capital gain that arises from the disposal may be excluded for CGT purposes. In this regard, two possible exclusions need to be considered, namely "the R2 million gross exclusion” and "the R2 million gain exclusion”.   

The R2 million gross exclusion will apply in the instance where the proceeds (selling price) of the primary residence does not exceed R2 million. In this instance, the full capital gain will be disregarded and as a result, no amount will be included in the calculation of the person’s taxable income.  However, it is important to keep the following in mind since the taxpayer will be prohibited to apply the R2 million gross exclusion if:

-       The taxpayer was not ordinarily resident in that residence throughout the period (on or after 1 October 2001) during which the interest in that property was held by the natural person or the special trust, or 

-       The residence was partially used for business (non-residential) purposes during the period (on or after 1 October 2001) in which the interest was held in that property. 

If the taxpayer does not qualify for the above-mentioned exclusion, the R2 million gain exclusion may still apply. It is important to note that this exclusion can be applied more than once in a person’s lifetime and may be utilised each time he or she disposes of a primary residence.

In addition it should be noted that the R2 million gain exclusion can only apply to the portion of the capital gain that relates to the residential use of the property. Let us assume the following situation: After 1 October 2001, a natural person buys a residence for R600 000 and uses 35% of its floor area to run a business throughout the period of ownership. The house is then sold for R2 650 000. 

In order to calculate the capital gain arising from the above disposal, one needs to subtract the base cost of the asset (amounting to R600 000) from the proceeds with disposal (which is R2 650 000). The capital gain arising from the disposal of the property is therefore R2 050 000. It is clear that the full capital gain does not relate to a primary residence since the person used the residence partially (thirty-five per cent) for business purposes. Therefore, only R1 332 500 (R2 050 000 x 65%) of the gain relates to the primary residence and will qualify for the primary residence gain exclusion. The excess capital gain which amounts to R717 500 (R2 050 000 x 35%) will therefore be included in the person’s taxable income, since it specifically relates to business usage. 

It can also happen that the property was not used for dual purposes (business as well as residential usage) during the entire period it was owned, but only for a certain part of that time. In such instances, the capital gain must be apportioned and, once again, only the portion that relates to residential use will qualify for the primary residence exclusion. 

In order to illustrate the above, let us assume that a person acquired property at a cost of R600 000 and used it solely as his primary residence for a period of ten years. Thereafter he started to use thirty-five per cent of the floor area of this residence for business purposes for a period of five years after which the primary residence was sold for R4 million. A capital gain of R3 400 000 (proceeds of R4 000 000 less base cost of R600 000) will arise. Next, the portion of the gain that relates to business use needs to be determined, since this portion will not qualify for the R2 million gain exclusion.

The business portion is determined by multiplying the capital gain of R3 400 000 with the total percentage of floor area used for business purposes (thirty-five per cent) as well as the total period during which the primary residence was partially applied for business purposes (five years out of a total period of fifteen years). This means that R396 667 of the capital gain relates to business use and will be subject to CGT. The excess of the gain amounting to R3 003 333 (R3 400 000 – R396 667) relates to residential use and qualifies for a maximum exclusion of R2 million. As a result the amount exceeding this exclusion, amounting to R1 003 333 will also be subject to CGT. In the end an amount of R1 400 000 (R396 667 + R1 003 333) will form part of the person’s net capital gain as a result of this disposal.  

It should be noted that the R2 million gain exclusion can only be applied to the portion of the capital gain that relates to property not exceeding two hectares and only for the period it was occupied as a primary residence. These factors also need to be considered to determine if further apportionment of the capital gain (that qualifies for the exclusion) is necessary. 

Conclusion

From the above it is evident that the following steps are involved in determining the CGT-implications of the disposal of a primary residence that was partially used for business purposes. First one needs to determine if the property complies with the definition of "primary residence” as set out in the Eighth Schedule to the Act. Furthermore, one needs to calculate the capital gain that arises with disposal and identify the portion of the gain that specifically relates to residential use since only this portion can qualify for the R2 million gain exclusion.  In the end, 33.3% of the capital gain, which does not qualify for the R2 million gain exclusion, will be subject to normal income tax. 


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