Paying Capital Gains Tax (CGT) isn’t necessarily a bad thing because it means that you have sold an asset and made a profit, which is better than a loss, of course. That said, I’m certain that most people would prefer to pay less tax, not more. Therefore, it’s important to understand the ins and outs of CGT.
Capital Gain Tax basics
The amount of tax you must pay on any capital gain is calculated using the below formula (for any asset purchase after 20 September 1985).
(A) Net sale proceeds – this includes the amount that you received less any direct selling costs such as advertising expenses, agent fees, legal fees, brokerage and so forth. If you have gifted the asset or sold it to a related party for less than market value, then your net sale proceeds are deemed to be equal to its market value.
(B) Cost Base – this includes the total cost of the asset, which is what you originally paid for it plus any related costs such as brokerage for shares, stamp duty and buyers’ agent fees for property, legal fees, professional fees and so forth. You may be able to include any holding costs and capital improvements in your cost base if you haven’t already claimed a tax deduction for them. The cost base will be reduced by any depreciation or amortisation claimed on the asset during the ownership period.
(C) 50% discount – if you have owned the asset for more than 12 months and you are a resident for Australian Tax purposes, you are entitled to reduce the net capital gain by 50%.
(D) Marginal Tax Rate – The final step is to multiple the discounted capital gain by your marginal tax rate. For example, if you earn between $120,000 and $180,000, your marginal tax rate is 39% (including 2% Medicare levy).
Leo purchased a property in 2002 for $550,000. The total costs associated with the purchase was $33,000. Leo sold the property in December 2021 and received $2.1 million net of all selling costs. As such, the gross gain is $1,517,000. The discounted gain is $758,500. And as Leo earns over $180,000 p.a. from his job, the whole gain will be taxed at the highest marginal rate of 47%. Consequently, Leo will have to pay $356,495 of tax when he lodges his tax return after 1 July 2022.
What if you make a capital loss?
A capital loss occurs when your net sale proceeds are less than your cost base. Capital losses can be used to offset capital gains. However, capital losses cannot be used to offset other income (such as employment income). Instead, you may carry a capital loss forward to use it in future years if/when you make a capital gain.
Main residence exemption
You are permitted to claim a CGT exemption on your home if (1) you and/or your spouse live in it, (2) you have not used it to generate an income e.g. rented it out and (3) the land is 2 hectares (2,000 sqm) or less.
Your spouse and you can only nominate one main residence at any one time. Therefore, if you have two homes (e.g. a city residence and a beach-side property), only one of those properties can be deemed as your main residence.
Various rules apply for different situations such as your main residence being on multiple titles e.g. adjoining vacant land, you have multiple dwellings on the same title, or you subdivided your main residence. In these circumstances, it is very important to obtain professional advice from a holistic accountant.
Converting a main residence into and investment property
If you rent out a former main residence, you may only receive a partial main residence exemption:
- If you occupied the property immediately after you purchased it, your cost base will be deemed to be equal to the market value on the day that it first became available for rent; or
- If you initially rented the property to a tenant, and occupied it thereafter, your main residence exemption will be pro-rata by the number of days that you occupied the property. For example, if you purchased a property and rented it out for 2 years, then occupied it for 5 years and then rented it out again for 3 years before selling it, then 50% of the gross gain can be disregarded under the main residence exemption (as you occupied the property for 5 out of the total 10 years you owned it).
If you rent out a former home and don’t claim another property as a main residence, you can continue to claim the main residence exemption for up to 6 years. This is called the-6-year-rule which is explained here. If you re-occupy the property prior to the end of the 6-year period, it is possible to reset this exemption for another 6 years. If you do no re-occupy or sell the property before the 6 years has expired, you will lose this exemption.
A company is not entitled to the 50% discount
A company is not entitled to use the 50% discount. As such, a company is taxed on the gross capital gain (i.e. items A minus B above).
If a company is eligible to be treated as a base rate entity, its tax rate will be 25% (for financial year 2021/22 and beyond). The maximum rate of tax payable by an individual is 23.5% (being the highest marginal rate less the 50% discount), so this company rate of 25% is only marginally higher.
However, if the company doesn’t qualify as a base rate entity, its tax rate will be 30%, which is prohibitively higher than an individual’s rate. If you are going to use a company to invest, care must be taken to ensure your business income structure allows you to benefit from the lower company tax rate.
Discretionary family trust
If a family (discretionary) trust crystalises a capital gain, it can distribute that gain to variously individuals and/or entities. Because trust distributions retain their tax nature and attributes, the capital gain will be taxed according to the beneficiary’s tax position. For example, if it is distributed to individuals, they will be entitled to the 50% discount, are able to offset capital losses and so forth. If it is distributed to a company, it will not benefit from the 50% discount. Essentially, the capital gain flows through to the beneficiaries.
Super funds are concessionally taxed. In accumulation phase (i.e. pre-retirement) a super fund is taxed at a flat rate of 15%. A super fund can apply a CGT discount of one-third if it has held an asset for more than 12 months. As such, the effective rate of tax on capital gains is only 10%.
In retirement (pension phase), the rate of tax is nil on all income and capital gains.
When you inherit assets, you inherit their original cost base and nature of the asset. This means if you subsequently sell the asset, you will be taxed on the full gain i.e. based on the predecessor’s cost base. In our experience, when inheriting assets that have been held for many decades, tax records can be difficult to obtain which can be challenging.
If you are selling the predecessor’s former home, you may be able to utilise the main residence exemption.
If the predecessor purchased the asset before 20 September 1985 (i.e. pre-CGT), then your cost base is deemed to be the market value as at the date of death.
Minimising Capital Gains Tax
Of course, you want to retain as much of any capital gain as possible, which means minimising your CGT liability. There are various ways you can do that, including:
- Crystalising the CGT event in the financial year that is most economical e.g. in retirement.
- Selling assets in the right order e.g. sell assets that are expected to crystalise a capital loss first.
- Gradually selling assets over many years – which is easier to do with shares.
- Proactively determine/plan the best use of your main residence emption.
- Structure asset ownership taking CGT liabilities into account e.g. trust or super fund. This is easier to do if you have a well-considering long-term strategy.
Warning: don’t rely solely on this summary
When it comes to tax, there’s almost always special rules, treatments and exemptions that depend on your circumstances (e.g. the Small Business Capital Gains Concessions). Whilst the above summary is accurate, it is important that you seek personalised tax advice to ensure these rules can be applied in your circumstances.