If you have trouble getting your head around "Capital Gains Tax" (CGT), you are not alone. It's a little confusing, but this article should help you understand more clearly - knowing where to start is the hardest part.
Capital gains tax is an area of taxation that often confuses property investors. The legislation can appear complicated, however, all investors need to have a good understanding of it before selling an asset.
Capital gains tax is the fee you pay on any profit made from the sale of an investment property. This profit is referred to as a capital gain. It is the difference between what you paid for the property (your cost base) and what you sold it for. It's included in your assessable income and taxed at your marginal rate.
So, when do you pay capital gains tax on an investment property?
Capital Gains Tax was introduced in Australia in 1985 and apply to any asset you've acquired since that time unless specifically exempted.
According to the Australian Tax Office, a capital gain or capital loss on an asset is the difference between what it cost you and what you receive when you dispose of it.
You pay tax on your capital gains, which forms part of your income tax and is not considered a separate tax – though it's referred to as CGT.
If an asset is held for at least one year, then any gain is first discounted by 50 percent for individual taxpayers or by 33.3 percent for superannuation funds.
CGT is included in an individual's assessable income and subject to tax at their marginal tax rate. There are specific rules for various "CGT events."
The most common CGT event occurs when a person sells or disposes of real estate or shares, and a profit or gain is made. There is a step-by-step system in place to help you work out the proper CGT calculation. When you break it down, it's quite simple.
Capital losses can be offset against capital gains, and net capital losses in a tax year may be carried forward indefinitely.
However, capital losses cannot be offset against regular income.
According to the ATO, most personal assets are exempt from CGT, including your home, car, and most personal use assets such as furniture. CGT also doesn't apply to depreciating assets used solely for taxable purposes, such as business equipment or fittings in a rental property.
When you sell or otherwise dispose of an asset, it's called a CGT event, which is the moment when you make a capital gain or capital loss.
It's also essential to establish the timing of a CGT event because it tells you in which income year to report your capital gain or capital loss, and may affect how you calculate your tax liability.
If you dispose of a CGT asset, the CGT event usually happens when you enter into the contract for disposal.
In the case of real estate, for example, the CGT event generally occurs when you enter into the contract – that is, the date on the contract, not when you settle. Click here to check out Government updates on COVID-19.
Has there been a capital gain?
If you have sold an asset (like property), you first need to determine if there has been a capital gain. Under the tax law, you can establish this by following these steps:
- Work out your capital proceeds from the disposal or sale
- Work out your "cost base" for the CGT asset (or the "reduced cost base" if a loss occurs)
- Subtract the cost base from the proceeds
If the result is a positive number (the profits exceed the cost base), the difference is your capital gain. If the result is a negative number (the profits are less than the cost base), then you have a capital loss.
How much is Capital Gains Tax?
The vast majority of people pay Capital Gains Tax on a rental property when they sell or dispose of it, so it's essential to understand how CGT is calculated.
CGT can be a little tricky to calculate, that's why it's so important to have specialists on your side – and especially a good taxation accountant.
Remember, CGT is only payable in the financial year in which you sell or dispose of your rental property.
So, if you follow a long-term wealth creation strategy, you won't need to worry about paying this for many years or possibly decades.
There are three options to calculate your capital gain
CGT Discount Method
If you're an Australian resident who has owned your property for more than 12 months, you're eligible for a 50% discount on your capital gain.
That's to say, if you made a capital gain of $100,000 from selling a property that you owned for more than 12 months, and sold it sometime after 21 September 1999, you would only add $50,000 to your taxable income.
If you're an Australian resident and purchased your property before 21 September 1999, you can use the indexation method to determine how much capital gain you will need to add to your taxable income.
This method applies a multiplier to your initial layout to account for inflation. (Think of it as the tax equivalent of saying, "in today's money, that would have been…".)
As a result, your initial purchase price is increased, and capital gain thereby reduced.
The multiplier you use is called the 'indexation factor.' It's calculated by dividing the consumer price index (CPI) at the time you sold your property by the CPI at the time you bought the property, rounded to three decimal places.
Using this method, you are only allowed to index the elements of your cost base up to 30 September 1999, regardless of how much later you sold your property.
Once you've worked out your multiplier, simply apply this to your initial cost price to get your inflation-adjusted purchase price. And then work out your capital gain by subtracting this amount from your actual sale price.
For assets held for less than 12 months before the relevant CGT event. To determine whether you acquired the asset at least 12 months before the CGT event, exclude both the day of acquisition and the day of the CGT event.
The basic method of subtracting the cost base from the capital proceeds.
Working out the discount percentages
Current tax laws allow you to take a discount percentage against your capital gain under specific circumstances. The discount is limited to certain CGT events. Also, the taxpayer must be a resident and must have owned the CGT asset for at least 12 months.
The discounts applied to the CGT event include a:
- 50% discount if the gain is made by an individual, certain trusts or a partner in a partnership
- 33 ⅓% discount if the gain is made by a First Home Save Account (FHSA), or a life insurance company from an asset that is a "complying superannuation / FHSA" asset, or a qualifying superannuation company.
Any capital gains that are eligible for the discount are called a "discount" capital gains.
Some situations can see you avoid capital gains tax entirely. Depending on your circumstances, you may be eligible for a full exemption.
Time of purchase
Property is exempt from capital gains tax if purchased before 20 September 1985.
Main place of residence
You can avoid paying CGT if you sell a dwelling that's considered your principal place of residence. You can only ever have one primary residence at any given time unless you're selling your old principal residence and buying another. In this case, you're entitled to an overlap period of six months as long as the new property will be your new primary residence, you lived in the old property for at least three continuous months in the 12 months before you sold it. It wasn't used to produce rent in this same 12 month period.
The ATO doesn't give an accurate description of what constitutes the primary residence, but gives the following points to consider:
- You and your family live in the dwelling.
- Your mail is delivered there.
- You have your personal belongings there.
- You're registered to vote at the property's address.
- You have connected a phone, gas and electricity to the property.
If you've lived in your home for the whole time you've owned it, haven't rented it out either entirely or to a lodger, and the land is smaller than two hectares, you'll get a full exemption on CGT when you sell. This is helpful if you plan to live the renovator's life: selling your home, moving into another, renovating it and then selling the renovated property. And while you won't make a rental income if you go down this path, all profits made from the renovation are exempt from CGT.
If you have to move out of your home and choose to rent it out, you may be exempt from some CGT liability under the 'Temporary Absence Rule.'
What is the rule? If you move out of your home and rent it out, under the law, the property is still treated as your principal residence for a period of up to six years. If you sell the property within this time from you will be exempt from paying CGT if you profit from the sale. You are also exempt from paying capital gains on the income generated from the leasing of the property.
If you're moving out of your home and renting it out, you're going to need somewhere else to live. You will need to select one of the two dwellings as your principal place of residence, and a tax will be applied to the sale of your non-primary property.
Buying a property through your SMSF is one way you can generate profits from residential real estate and avoid paying CGT. You use your super fund to purchase the home along with an SMSF property home loan to make up the total. The loan is then paid off through your super contributions.
If you sell the property once you've retired, you'll pay no capital gains on the property. Even if you sell the property while you're still accumulating your super, this will be taxed at a rate of only 15%. Holding onto the property for longer than a year will effectively drop this rate to 10%.
Buying a property with your SMSF comes with some risks, so you should never attempt it without first seeking professional advice.
Working out your net capital gain
Each of your capital gain events must be calculated separately; then the results must be added together to figure out your net capital gain. To complete this calculation, you must:
- Reduce your capital gains for the current income year, by your current year capital losses (you have a choice to apply capital losses to either discountable or non-discountable capital gains).
- Reduce remaining capital gains by any unapplied capital losses from previous income years.
- Reduce any remaining capital gains by the applicable discount percentage. (see above)
- Apply any special business CGT concessions to which you may be eligible.
- Add up any remaining capital gains (discounted and non-discounted)
This total should be your net capital gain and is included in your assessable income.
Make sure not to confuse a capital loss with a "revenue loss." If you have incurred a revenue loss, you may be able to deduct that from your assessable income. Certain rules apply to the loss, and specific laws dictate which ones are eligible (especially for companies and trusts). If you would like additional information, need help to calculate your CGT, or if you have any questions regarding eligibility, please contact this office for assistance.
Hillyer Riches Management Pty Ltd , your Caulfield accountants, is a Corporate Authorised Representative (No 466483) of Capstone Financial Planning Pty Ltd. ABN 24 093 733 969. AFSL / ACL No. 223135. This document contains general advice only and is not personal financial or investment advice. Also, changes in legislation may occur frequently. We recommend that our formal advice be obtained before acting based on this information.