The Australian Federal Government is still grappling with an unintended tax consequence, often dubbed the ‘widow’s tax,’ nearly three months after its May Budget. While a recent legislative fix addresses issues related to investment property tax breaks upon death or divorce, a more significant problem concerning capital gains tax on unrealised gains remains unresolved.
The ‘Widow’s Tax’ Explained
The core of the issue lies in how capital gains tax (CGT) is applied when assets are transferred due to death or relationship breakdown. Historically, certain tax concessions, such as negative gearing and the 50 per cent capital gains tax discount on investment properties, were ‘grandfathered’ – meaning they continued to apply even after ownership changed hands. However, changes introduced in the May Budget failed to carry these concessions through for transfers resulting from death or divorce.
Draft legislation released this week aims to rectify this specific problem for investment properties. It seeks to ensure that when an investment property is transferred to a spouse or ex-spouse, the original tax treatment of negative gearing and the CGT discount is maintained. This would prevent an immediate, unintended tax liability on the property’s appreciation.
The Unresolved Capital Gains Tax Conundrum
However, estate planning lawyer Rachael Rofe, principal solicitor at Rofe + Co, highlights that this legislative fix is only partial. A broader and more concerning issue persists: the potential for capital gains tax to be levied on ‘notional’ or unrealised gains on various assets, including rental properties and shares, when they are transferred due to widowhood or divorce. This tax could be triggered even if the asset hasn’t been sold and no cash has been received by the beneficiary.
According to Ms. Rofe, any asset that has increased in value could become subject to CGT on these unrealised gains from July 2027, unless further legislative action is taken. “Any asset that has had a gain will be subject to capital gains tax when the asset moves to another entity or person as a result of death or divorce,” she explained. “The issue is, like, it is still a widow tax. I’ve seen lots of people out there say, ‘Widow tax is fixed’ — no, it’s only half fixed.”
The problem is particularly acute for widows. Upon the death of a spouse, they might inherit an asset that has significantly appreciated in value. Under the current, unresolved provisions, they could face a substantial tax bill on this unrealised gain, despite not having sold the asset and therefore having no immediate funds to pay the tax. “She doesn’t receive money for inheriting the asset. How is she going to pay this tax? There has not been a cash liquidity event,” Ms. Rofe stated.
How the Tax Would Apply
The tax liability on these notional gains, accrued up to June 30, 2027, would initially benefit from the existing 50 per cent CGT discount. However, from July 1, 2027, the remaining gain would be taxed at the widow’s or divorcee’s marginal tax rate. Ms. Rofe cautioned that the current legislative drafting could inadvertently trigger this deferred gain upon transfer, irrespective of a sale or cash receipt.
Broader Tax Reform Concerns: Trusts Under Scrutiny
Beyond the ‘widow’s tax’ issue, the Federal Government is also facing significant pushback regarding its proposed reforms to the taxation of discretionary trusts. From July 1, 2028, the government plans to impose a minimum 30 per cent tax on income generated by ordinary discretionary trusts, alongside a similar minimum CGT rate.
These trusts are commonly used by small businesses for asset protection, shielding them from creditors in case of business failure or liquidation. The Australian Chamber of Commerce and Industry (ACCI) estimates that this reform could substantially increase the tax burden on small businesses.
ACCI chief executive Andrew McKellar cited an example where an average small business trust earning $161,000 annually could see its tax bill rise from approximately $29,300 to $48,300. “This tax is not about hitting high-wealth individuals, it’s about hitting your local tradie, café owner or hairdresser,” Mr. McKellar asserted. “These are hardworking Australians who don’t deserve to be hit with high taxes and red tape.” He also warned of the significant impact on businesses needing to restructure due to these changes.
Testamentary Trusts vs. Ordinary Discretionary Trusts
The draft legislation does, however, cancel a previous Budget proposal to tax discretionary testamentary trusts – trusts established for estate planning to protect inheritances. Despite this concession, ordinary discretionary trusts will still be subject to the proposed minimum 30 per cent tax rate.
Political Reactions and Next Steps
Opposition figures have criticised the government’s handling of these tax matters. Acting Opposition Leader Jane Hume suggested that the ‘widow’s tax’ issue should have been addressed during the previous parliamentary sitting. “Let’s see what Jim Chalmers comes up with next. He’s already decided to roll back the widow’s tax, something that they could have done at the last sitting, but they chose not to,” she commented.
Ms. Hume also voiced concerns about the proposed trust tax, characterising it as an attack on legitimate business structures. “They chose not to. And the next exciting episode is going to be a tax on trusts, a tax on trusts, which is a perfectly legitimate business structure and has been for decades. But Labor likes to accuse people that use a perfectly legitimate structure of avoiding tax,” she added.
Both houses of Parliament are set to resume next week. Consultation on the ‘widow’s tax’ and the exemption for discretionary testamentary trusts is ongoing, with submissions due by August 21. The government faces the challenge of resolving these complex tax implications to avoid unintended financial hardships for individuals and businesses.
