Tax deductions for residential rental property, such as we looked at last issue, are always highlighted in glossy sales brochures for new developments, and they often look too good to be true. I have a brochure for an office building that is being converted to apartments that says that if I buy an off-the-plan apartment for $395,000 I can claim deductions of about $60,000 for depreciation and building costs in the first five years of ownership. While this is true, it only tells half the story.

What it fails to mention is the capital gains tax and depreciation claw back rules that apply when that property is sold. These mean that the cost base of the apartment will be reduced to $335,000 when the capital gain or loss is calculated, and depending on the depreciation claimed there may be a balancing amount that is taxable or deductible in respect of the depreciable assets. It is therefore important to understand how these rules work.

Gains made on property acquired before September 20, 1985 are not usually taxed, but if you acquired a residential rental property on or after that date, the capital gain you make when you dispose of the property is taxable under capital gains tax (CGT) rules.

If you acquired it before 11.45am on September 21, 1999 you have the choice of indexing the cost base of the property or taking a 50 per cent discount from the calculated capital gain. Capital gains made on property acquired after that time are eligible for a 50 per cent discount once you have owned them for at least 12 months.

When you sell (or otherwise dispose of) a residential rental property you need to include details of the capital gain or loss in your tax return. The same generally applies if you dispose of it in some other way, for example you transfer it to your spouse (the exceptions are discussed below).

When you sell a residential rental property, you may need to make some adjustments to the cost base if you have claimed tax deductions for certain items. These deductions include those made for building costs and capital works and depreciation on assets that will remain in the rental property (as discussed in this column last month).

There are two different rules for deductions that have previously been claimed for building costs and capital works. Where the property was acquired before 7.30pm on May 13, 1997 the cost base is only reduced by those claims if there is a capital loss. Where you acquired it after that time, the cost base is reduced to calculate both a capital loss and a capital gain.

In the case of depreciation on assets that remain in the property, such as hot water service, carpets and curtains, deductions are recouped via a balancing adjustment and so are not taken into account in the capital gains tax calculation. You work the balancing adjustment amount out by comparing the asset's termination value (sale price) with its adjustable value (written down value) at the time of the balancing adjustment event. Where the termination value is more than the adjustable value, you include the excess in your assessable income. Where the termination value is less than the adjustable value, you can deduct the difference.

For example, Jim bought a two-year-old residential rental property for a total of $200,000 on July 1, 2000 including $30,000 of depreciable assets (called plant). The original cost of the building was $100,000. After spending $14,000 on structural improvements, Jim sells the property on June 30, 2003, and selling costs are $10,000.

The value of plant in the sale price is shown in the contract at $20,000, and so far Jim has claimed deductions of $11,576. Jim has CGT and balancing adjustment issues to sort out.

Jim's cost base for CGT is $186,500 (net purchase price $170,000 plus capital expenditure $14,000 plus selling costs $10,000 minus capital works deductions $7500). If he sells the property for less than $186,500, the difference is a capital loss. Lets assume though that he sells it for $310,000.

Jim's total capital gain from the sale of the property is $103,500 ($290,000 minus $186,500). Assuming he has no carried forward or current year capital losses, he can reduce the capital gain by 50 per cent discount, so that the taxable capital gain he will include in his assessable income is $51,750.

Plant is exempt from CGT rules, however a balancing adjustment must be calculated. In this example, it is the original price of $30,000 less the decline in value of $11,576 already claimed as a tax deduction.

This ensures that total depreciation deductions correspond to the actual amount recouped by Jim. As the sale price is $20,000 and the written down value is $18,424, Jim must include $1576 as a balancing adjustment in his assessable income and taxed at his marginal tax rate.

There are some exceptions that allow you to defer paying tax on capital gains in certain circumstances regarding property on marriage breakdown. Deferral may be available when a married or heterosexual de facto couple separate and the residential rental property is transferred between the former spouses.

However, this only applies if the transfer occurs as a result of a court order or court-approved maintenance agreement under the Family Law Act, or a state, territory or foreign law relating to de facto breakups. In this case the spouse who owns the property after the transfer will calculate any capital gain or loss when he or she disposes of the property using the original cost base.

For reasons best known to the politicians in Canberra, CGT cannot be deferred where the property is transferred between happily married couples for love and affection or following the mutual friendly agreement of the separating spouses without going through the above court formalities.

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