how to utilise Capital Gains to optimise your investments

capital gains tax australia

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Income made through capital gains is more tax-efficient than other income.

It can compound tax-free for decades during the accumulation phase and then be taxed at half the rate of other income. The timing of asset sale for a low-income financial year will reduce your tax rate.

Shares are easier to liquidate in tax-efficient lumps each tax year, whilst property investments are well suited to holding forever, or occasionally inside superannuation.

Purchasing a great quality home in a fantastic area is a popular strategy as your home can be sold tax-free. Active assets (ie a business premises) valued up to $500,000 can also be sold capital tax-free on retirement.

What Are Capital Gains?

Capital gains or losses are the difference between your purchase and sale price of an asset. A capital gain is when you make money, a capital loss when you lose money. Capital gains tax is payable on assets such as shares, property, cryptocurrency, foreign currency and collectables worth more than $10,000. You must declare capital gains on your tax return. But capital losses can sometimes be used to offset gains and reduce tax.

You “realize” a capital gain when you sell an asset that has increased in value from the cost base. The cost base includes the purchase price and costs involved in purchasing and holding the asset. These include stamp duty, transfer fees, borrowing expenses (loan application fees, discharge fees), advertising costs to find a buyer.

Renovation costs to improve a property valuation are added to the cost base. Repairs to maintain the property, in contrast, are deducted against income in the same year. Find further details on cost base inclusions on the ATO cost base page.

If you brought a parcel of shares for $100,000 and sold them for $120,000 your capital gain would be $20,000.

All the time you don’t sell an investment, your capital gains are compounding completely “unrealized” and untaxed. It’s a fantastically efficient way to build wealth whilst you are still working.

Does the ATO Consider Capital Gains Income?

Rather than being a separate tax, the ATO taxes capital gains at your individual (or company’s) marginal rate. The capital gains realized are added to your taxable income. As opposed to your PAYG income, you can get a significant tax discount on income from capital gains.

Income is taxed at a flat rate of 30% for companies, and between 0 and 45% for individuals, depending on their taxable income.

What is the Capital Gains Discount?

Assets held for more than 12 months are eligible for a 50% capital gains tax discount.

This means if you had held those $100,000 worth of shares for over 12 months, and sold them for $120,000 you would only have to pay tax on $10,000 of the $20,000 capital gains.

If you could convert all your income to capital gains, you would pay half as much tax! Not only are capital gains a great way to compound earnings untaxed whilst working, but they are also taxed more efficiently than any other income when you do sell.

It seems counterintuitive that you pay less tax on passively earned investment income than income from hard work, but this is part of what makes investing so appealing.

Capital Gains Can be Lumpy

People often think of capital gains tax in relation to property. Selling a property can result in massive capital tax bills, as you have to sell the whole thing at once. Capital gains property can slow your journey towards financial freedom if this isn’t carefully planned out.

A more tax-efficient way to produce income is an even amount each year, ideally shared between two or more individuals.

A $500,000 capital gain from selling your investment property will incur a huge tax bill, pushing even a non-earner into the top tax bracket.

Buying a block of units, or a strip of shops could reduce this lumpiness, as units or shops could be strata-titled and sold off separately. This would be a high-value investment though, with significant concentration risk from investing so heavily in one street. The investment strategy needs to make sense first, the tax strategy should come after.

Shares, on the other hand, can be liquidated in small chunks, allowing capital gains to be evenly spread over years, incurring little capital gains tax.

FIRE stock market investors can take advantage of this. If they invest enough in shares (ETFs or LICs) that produce minimal dividends and withdraw their living expenses every year, they can pay no, or very little tax. Dividends, in contrast, are taxed at the individual’s full marginal rate.

There is an alternative method to adjust how much of your capital gain is taxable, based on adjusting the capital gains for inflation. This is now only relevant to assets purchased before 30th September 1999. Find out more about the indexation method on this ATO page.

Companies and foreign residents purchasing assets after May 2012 are not eligible for the 50% CGT discount.

Capital Gains Tax Exemptions

Your primary residence is usually exempt from Capital gains tax. It has to be on less than 2 hectares of land and you must not have used it to run a business. This is why many people like the strategy of buying the best house they can stretch their budgets to afford. On downsizing, they can sell and make a good profit (if they brought well and could afford to maintain the place). Some of this cash can then be contributed to superannuation.

You need to move into your home as soon as practicable after purchase to be eligible for CGT exemption. If you move into a previous investment property, it will not become eligible for capital gains tax exemption.

Properties purchased before 1985 do not attract any capital gains tax.

“In this world nothing is certain but death and taxes.”

Benjamin Franklin

Temporary Absence Rule

The temporary absence rule means that you can rent out your previous main residence for up to 6 years without losing the CGT exemption. This is a fantastic deal for those that have to move for work but can also be utilised by retirees moving to their final home. If you move back in after six months of renting, it resets as if you never rented out again, so you could rent it for another 6 years.

If you purchase a new home, you do not need to decide which you will treat as your main residence for CGT immediately. There is a 6 month grace period where you can treat both as your main residence. When you sell one of the homes, you will need to decide whether you want to use the CGT exemption for it (and lose it for the other home).

You will need to know the value of the home at the time it ceased to become your main residence in order to claim a partial exemption, so ensure you value the home when you move out in case your new home is the one you end up claiming as your main residence.

What is a Capital Loss

A capital loss is realized when you sell an asset for less than you brought it for. This is obviously exactly the opposite outcome to the one you want. But the capital loss can be used to reduce capital gains tax. Capital loss cannot be used to reduce your taxable income (eg taken off your PAYG income) but can be used to reduce the capital gains tax payable.

If you brought shares for $100,000 but sold them for $90,000, you would have a $10,000 capital loss 🙁

If, during the same or subsequent tax years you sold that investment property for a $500,000 gain you could use the $10,000 capital loss to reduce your capital gains tax obligation. Instead of paying capital gains tax on $500,000, you would pay it on $490,000 (or half of that if eligible for the 50% discount).

You can “Carry forward” a capital loss for an unlimited amount of time. This means, as long as you keep the documentation proving your capital loss, you can use it to reduce capital gains tax when you sell a profitable asset. As long as the rules don’t change in the meantime of course.

You cannot “Carry forward” a capital gain. The tax is payable with your income tax return at the end of the financial year.

This means timing of sale of your dud investments (if you have any) is important.

Capital Loss Harvesting

Capital loss harvesting is timing a sale of a loss-making investment to reduce taxation of a capital gain. You cannot sell an investment (eg your ETF during a market dip) to rebuy a similar one. This is known But if you had a dud investment you were wanting to sell, you can use the opportunity to reduce a capital gain.

Capital Gain Harvesting

Capital gain harvesting is a technique you can use if you plan to switch out of one form of investment to another. An example would be graduating from a micro-investment app to your 1st brokerage account. If the sale of the assets within the micro-investment account was timed in a year of no or low income, little or no CGT would be payable. The new investment can then be purchased, resetting the cost basis.

Sally

Sally opened a RAIZ account and invested $500 per pay. Sally has invested $26000 and has benefitted from $5000 in growth. Sally waits until she is on 1-year unpaid maternity leave to sell her RAIZ investments tax-free and purchase ETFs through her new brokerage account. The new cost basis is $31,000, so only gains above this will be taxable when Sally eventually sells.

Wash Sale Rules

A wash sale is a sale of an asset primarily intended to achieve a tax benefit. It counts as tax avoidance, is illegal and land you in hot water with the ATO, a position no one wants to be in! Optimising a capital gain or loss should be a case of timing a move you were planning to make anyway, not purchasing or selling primarily for a tax benefit.

Special Circumstances – Divorce and Inheritance

The tax treatment of your inherited property depends on how the property has been used before and after inheritance. No capital gains tax is incurred on inheritance. If the deceased always lived in the property, it’s cost base will be the value at inheritance. The property will remain CGT exempt if you then move into the home.

If you rent the property, the CGT exemption only applies to the time before it was inherited, so you will need a valuation at the time of inheritance. Get independent advise if you are in this situation to make sure you get it right.

In the other unfortunate situation of divorce, assets can be transferred as part of the settlement. The capital gains are deferred and the transfer inherits the original cost base. So if you divorce and your ex-partner gets the investment property, no tax is payable on the property when transferred and your ex-partner will eventually pay CGT if the property is sold as if they owned it in their own name all along.

Can Capital Gains Tax be Avoided?

Investments decisions should be made based on tax outcomes. But the tax situation should be optimised as much as possible, once an investment strategy is chosen.

In order to completely avoid capital gains tax you could:

  • Not make any profit (But what’s the point of that)
  • Purchase your large lumpy asset inside superannuation and sell in the pension phase so gains are tax-free. The costs and hassle of managing a self-managed super are a major deterrent to this, as well as more expensive and limited options when leveraging inside superannuation. Get professional independent advice if considering an SMSF. Income during accumulation from rent or dividends will be taxed at only 15% and capital gains at a discounted 10%.
  • Sell a little at a time, with no other taxable income, to remain under the tax-free limit of $18,400 per person
  • Never sell. Keeping assets long-term is an ideal situation, receiving small amounts of tax-free income from outside superannuation and the rest from within super (which is tax-free anyway).

How to Reduce Capital Gains Tax

Paying tax means you are making a profit, so it can’t be all bad. It also pays for our schools, hospitals, roads and much more. But it’s not used all that efficiently much of the time, and few people wish to pay more than their fair share. Here are a few ways you could reduce your capital tax liability:

  • Time the sale of assets in a low-income year (eg post-retirement, parental leave etc)
  • Consider carefully the tax implications at the beginning, duration and sale of an investment and choose who should own the asset after weighing all this up (individual, trust, company, super).
  • Consider using the temporary absence rule. Rent your main After moving out of your home (principal place of residence) you can rent it out for up to 6 years before it becomes eligible for capital gains tax. This is ideal for those having to move across the country for work and planning to return. It can also be used to squeeze a few more years of capital gains (and rental income) out of your penultimate home before retirement.
  • “Active assets” eg assets used for a small business are eligible for a 75% discount if owned for more than 12 months. If an active asset is owned for 15 years and you sell it aged over 55 years to retire, up to $500,000 is exempt from CGT. Capital gains can also be deferred on selling an active asset and rolled over into a new asset. See the ATO page on active assets for more details.

Understanding the tax treatment of investments allows investors to own their assets in the most efficient structure, and time investment moves to minimize tax.

Coming up to tax time fast! What are your tips for getting your tax return organised? Comment below to share your tax hacks.

Aussie Doc Freedom is not a financial adviser and does need offer any advice.  Information on this website is purely a description of my experiences and learning.  Please check with your independent financial adviser or accountant before making any changes.

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