Capital Gains Tax looks and sounds daunting, particularly for those investors who haven’t been in the game for a long time, but once you understand a little more about it, it’s actually not all that confusing.
Let’s take a look at what exactly Capital Gains Tax is, when it is applied and how it is calculated.
What is Capital Gains Tax?
Capital Gains Tax affects many investments that we hold, but it is mostly known in regards to investment properties. Capital gains is really just the difference in the value of an asset from when you purchased to when you sold (less any fees incurred during both the purchasing and selling process).
Capital gain tax (or CGT), therefore, is the tax you pay on the gain from the sale of the asset. It applies to property, as well as shares, leases, licenses, foreign currency, contractual rights, goodwill and personal use assets that you’ve purchased for more than $10,000.
Any purchase of a car, main residence or depreciating asset that has been used solely for taxable purposes and assets purchased before 20 September 1985 as exempt from CGT. However, if your main residence sits on more than two acres of land or you’ve not resided in the property for the entire period of ownership, you may be afforded only a partial CGT exemption on your home.
When it comes to selling your home, or any asset that attracts CGT, it is well worth making an appointment with your accountant to discuss your tax obligations.
How much is Capital Gains Tax?
This is where people tend to get confused. Capital gains tax isn’t a stand-alone tax; it all forms part of your income tax when you do your tax return every year.
If you have purchased and sold an investment property within a 12 month period, your net capital gain - that is, the difference between the sum of your capital gains and the sum of your capital losses - is added to your taxable income, increasing the amount of income tax you pay. If you are employed, you may end up with a tax bill.
Where it starts to get a little more complicated is when you’ve owned the property for more than 12 months. For those who buy and sell as a business, you don’t receive any discounts and pay a flat 30% on your capital gains, while those who have purchased and sold as part of a self-managed super fund apply a 33.3% discount to their capital gain, and pay 15% tax on the remaining.
Calculating Capital Gains Tax
When it comes to paying capital gains tax, your best bet is to use an accountant. They can work it all out for you when it comes time to lodge your tax. In saying this, it is, of course, beneficial if you have a good idea of how the process works.
As we mentioned above, if you’ve purchased and sold within 12 months, your gains are added to your taxable income. For those who’ve owned an investment property for more than 12 months, there are two different methods that can be used to calculate CGT - discount and indexation. Depending on your eligibility, you may be able to choose which method you use, leading to a lower possible capital gain.
CGT Discount Method
As an Australian resident, if you’ve owned your investment property for more than 12 months, you are eligible for a 50% discount on your capital gain.
This means if you made a gain of $200,000 from selling a property you owned for more than 12 months, and you sold it after 21 September 1999, you would only add $100,000 onto your taxable income.
CGT Indexation Method
If you purchased your property prior to 21 September 1999 and you are an Australian resident, you can use the indexation method to determine how much capital gains you need to add to your income come tax time.
The indexation method applies a multiplier to your initial layout to account for inflation. Essentially it is the tax equivalent of “in today’s money, that would have been equal to…”. As a result, the initial purchase price is increased, and the gains are effectively reduced.
The indexation factor multiplier is calculated by dividing the CPI (consumer price index) at the time you sold your property by the CPI at the time you purchased your property and rounded to three decimal places. Not sure what the CPI was at the time of purchasing? You can find historical CPI figures here.
You will need to remember that if you use the Indexation Method, you can only index the elements of the cost base to 30 September 1999, regardless of how long after that date you sold your property.
To work out this method, once you have the multiplier, add this to your initial cost price to get the inflation-adjusted purchase price. You can then work out your capital gains by subtracting this amount from the sale price.
Confused? We don’t blame you. Here’s an example:
Purchase price of the property: $200,000
Purchase date: 10 August 1990
Sold price of the property: $500,000
Sold Date: 10 March 2018
For this calculation, we are going to assume that you paid the deposit and settled in the same quarter. So you would divide the CPI in the third quarter of 1999 by the CPI of the third quarter of 1990. Why 1999 when you bought in 1990? Because you can only use the elements up to 30 September 1999.
So this calculation works out to be: 68.7/57.5 = 1.195 (rounding to three decimal places.
You then need to work out your inflation-adjusted price. So take that purchase price of $200,000 and multiply it by the 1.195. This gives you an adjusted cost base of $239,000.
Then you need to minus this from your sold price:
$500,000 - $239,000 = $261,000. You then add the $261,000 to your taxable income for the year.
Capital Loss Method
You’ve probably heard some investors say they have made a capital loss from property investment. Despite increasing property prices, this can happen. To reduce the amount of capital gains you pay, if you have made a capital loss, you can deduct this from any other capital gains you have made (including from other sources).
Don’t have any capital gains in that same tax year? You can carry over capital losses to subsequent years to bring your tax down.
If you’re even slightly confused about how to work out the CGT or which method works best for you, make an appointment with your accountant.
How to Avoid Capital Gains Tax?
Generally, you will pay some tax when you sell an investment. But that can be reduced by keeping all relevant receipts. Any costs that you incur during the purchase or through improving the property may be able to be added to your cost base. The higher that you can prove your cost base is, the lower your capital gain.