There are many regulations and exceptions to the rule regarding capital gains tax (CGT) that it can be a confusing concept for many people. Considering that the official Australian Tax Office CGT guide has more than 170 pages, it’s no wonder why.
While we can’t provide a comprehensive guide in just one blog post, we will outline the major concepts to help you understand the basics.
Because CGT is ubiquitous in real estate transactions, this is something you should discuss with your accountant and incorporate into your property management plan.
What is capital gains tax?
Capital growth is the net increase in value of your investment property over time. For example, let’s consider you purchased your home ten years ago for $200,000, including all costs, and it is now worth $600,000. The capital growth in this scenario would be $400,000.
When you sell your property, the Australian Tax Office deems the $400,000 you made on your property as income. As a result, you are taxed on that money when you lodge your next income tax return.
It’s important to note that calculating potential capital gains or losses is a little more complex than simply deducting your original purchase cost from the final sale price.
CGT is based on three main factors: cost base, who owns the asset, and time held.
The cost base is determined by considering the money paid for the property, incidental costs of buying the property, the costs of owning the property and the costs of increasing or preserving the property’s value.
CGT is also calculated based on whether you’re an individual or a company. If you’re an individual, the rate paid is the same as your income tax rate for that financial year, a maximum of 45%. Companies pay a maximum of 30%. If you own the asset as part of a self-managed super fund (SMSF), you’ll generally pay 15% in the accumulation phase and 0% in the retirement phase.
The last metric CGT is calculated on is the time you’ve owned the asset. If you hold the property for more than 12 months, for example, you’ll be eligible for a 50% discount on your CGT.
Dean and Amber purchased an investment property for $500,000. They sold it three years later for $640,000.
Let’s look at the three main factors: cost base, time owned and who owns the asset.
1. What is the cost base?
- Purchase price: 500,000
- Stamp duty: $22,000
- Other buying costs: $3,200
- Renovations: $24,000
- Agent fees on sale: $18,000
- Other selling fees: $2,200
- Total cost base: $569,400
To calculate the capital gain, we subtract the cost base from the sale price.
- Sale price: $640,000
- Less cost base: $569,000
- Capital gain: $70,600
2. How long have they held the property?
Dean and Amber held the property for more than a year, so they’ll be eligible for a 50% discount on the $70,600 gain, which comes down to $35,300.
3. Who owns the asset?
Dean and Amber are individual taxpayers. They don’t own the property through a company or an SMSF.
The total capital gain for tax purposes is $35,300. As the property was held 50/50 between Dean and Amber, they will have to split this up between them, so they each pay tax on their portion.
Dean’s annual income is $100,000, and Amber’s is $110,000. They both fall under the same taxable income bracket:
Without considering any deductions, Dean’s tax payable is $22,967. Because he is an employee, the tax was taken out during the year from his payslip.
After adding the capital gains, Dean’s annual taxable income will be $117,650. Adding the capital gains to his current taxable income didn’t change his income bracket, but it increased his tax bill to $28,703.25.
Dean’s Taxable income with capital gains
There is an exemption on CGT if the property is a principal place of residence. Several guidelines determine whether or not your circumstances will allow your property to fit into this category. Suppose you haven’t physically lived in the property the entire time you have owned it. In that case, your eligibility for principal residence exemption will largely rely on your ability to prove things like the length of time you lived there, where you have your mail delivered, and your electoral roll address.
Most properties purchased prior to the implementation of CGT on 21 September 1985 are exempt from CGT.
In the unlikely scenario of selling a property for less than its cost base, you’d have a capital loss. CGT wouldn’t be applicable in this scenario because there are gains to be taxed. You can also carry this loss forward to use it to reduce any capital gains in future years.
What has an impact on capital gains?
The greatest influence on driving up capital gains is the age-old concept of supply and demand. Simply put, if a lot of people are moving to or want to buy in a specific area, property prices go up.
Inflation can also impact capital growth as it places upward pressure on the salaries of builders and the costs of materials needed to build new homes. This rise will flow onto all surrounding homes, even if they were built for less in the past.
The property value is calculated by combining two components – the land on which the property is located and the physical building. The land is the component that increases in value because of supply and demand. Land is a finite resource; once it has been developed, you cannot make any more.
The house/unit/townhouse/duplex built on the land, in contrast, depreciates over time. As the structure ages and areas like the kitchen and bathroom age, the value of the bricks and mortar on the property decreases. Of course, most investors would end up spending some money on upgrades when purchasing an existing property and this is one thing that is not well measured in real estate. It is known as capital expenditure and billions of dollars are spent on it by property owners and investors every year.
Minimising CGT liability
You’ll most likely be charged CGT if you sell an investment property purchased after 1985. However, there are some ways you can navigate this so that you pay as little as possible while still working within legal frameworks.
The first is straightforward – hold onto your properties for at least 12 months. When you consider the current formulas in place to calculate CGT, you will pay more on a property if you sell it before you have owned it for 12 months or less. This is where you need to weigh up any desire for a quick profit with a little more patience so that a larger portion of your profit doesn’t get gobbled up by the taxman.
While capital losses are not desirable, they can be helpful in reducing CGT. This is because they can be carried over to the subsequent tax year. This means when you have multiple properties, and you sell one at a capital loss, the following financial year is the ideal time to offload a property that has increased in value, as you will be paying less in CGT.
Keeping detailed records of the costs of owning your property is a good habit to pick and keep consistent. In most cases, these can be offset against the amount you owe in CGT. Remember that writing things down on a scrap piece of paper is not going to cut it; you will need to have detailed records with relevant receipts and other documentation. In this case, it’s better to keep everything you think might be relevant than to throw out something you find out later would have been beneficial to a CGT reduction. So keep all your records in a little folder!
We’ve said it already, but CGT is a complex area and having the best possible advice from experts will ensure you are on top of how you can minimise your CGT commitment.
We have a team of in-house financial and property advisors and accountants that can help you with that. Click here to book a free chat today.
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