When talking about investing you may have heard of the term “capital gains tax”. This is usually referred to when an investor has made a profit from selling an investment. But what is this tax, how much does it cost and when is it incurred?
What are capital gains?
Firstly, to understand how capital gains tax works you need to understand capital gains. Capital gains are simply monetary gains from when you have bought and sold an asset. Therefore, capital gains tax is simply the tax incurred to you the investor by selling your asset for a profit. Note, CGT only applies when you sell your asset and make a profit. So, as long as you hold the asset even if it increases in price, you are not liable for CGT. Knowing this we can now discuss the implications of capital gains tax and how it may affect your investment decisions.
When is it paid?
You incur CGT at the end of each financial year (assuming you made a capital gain within that financial year). CGT is calculated by adding your capital gain to your pre-tax income to determine the amount of CGT required to pay. Things that impact your CGT include your salary, capital gain amount, potential deductions or capital losses, expenses that occurred with owning the asset, and the duration of owning the asset. There is no one set amount paid for CGT as it is considered on a case-by-case basis.
Exemption to CGT
Fortunately, there is one benefit the government gives to investors who are dealt with paying tax on their profits. If you hold an asset for the duration of a minimum of 12 months you are eligible for a 50% CGT exemption. That means as long as you hold your asset for a year you will be able to pocket at least 50% of your profit, tax-free. This is great news for longer-term investors but makes it difficult for short-term investors. If you invest with a smaller time frame such as over a period of weeks, days, or even minutes you will incur the full force of CGT. Take the following example to understand how this tax is calculated:
Investor A earns 100k per annum in the financial year of 2020/21. A 100k salary would normally incur around 24k of tax assuming no deductions were claimed. This means investor A stands to pocket 76k post-tax this financial year. However, Investor A purchased 100k of stocks 2 years ago and has recently sold his stock portfolio for a 50% gain. What amount of CGT would he incur?
With 50% growth, the asset would be worth 150k at the end of the two-year period. Given he held the asset for over 12 months he would be eligible for the 50% CGT exemption. His capital gain (50k) is added to his pre-tax income (100k) and is considered “income” in the financial year he made this gain. His original capital (100k) placed into stocks is not taxed and his 50k gain is halved due to the exemption. So, his annual income becomes 150k this financial year, but he is only taxed on 125k due to his exemption. 125k is taxed down to roughly 91k so he needs to pay 34k tax this year. He has already paid 24k from his salary, so his CGT equates to 10k.
After-tax, Investor A received 116k (76k from his salary, 40k from his stock portfolio). So, he ended up paying an additional 10k worth of tax from his 50k gain. This would equate to a 20% tax on his total profit.
If you are looking to calculate your own capital gains tax you may wish to visit the ATO website where they outline the process of calculating your CGT.
Application to all assets
It is also important to understand capital gains tax applies to all asset classes. Regardless of whether you invest in property or stocks or cryptocurrency you are taxed for making a capital gain. So, when contrasting investment classes CGT puts them all on the same playing in terms of tax paid when selling for a profit. Now it is important to note this also works in reverse. That is to say, when you make a capital loss you can use this further down the track to minimise your capital gains tax.
The government’s incentive
The government’s justification behind the implementation of this tax can be quite clear. By taxing investors gain the government stands to make a hefty profit from individuals who create a profit through investing. In addition, by taxing investors the government can attempt to minimise the potential wealth gap between successful investors vs non-investors. Therefore, the government is incentivised to implement this tax as they stand to profit significantly.
How does this impact property?
Due to the significance of capital gains tax, its impact on property is quite substantial. Many investors mold their investment strategy around avoiding this tax at all costs. An investor’s approach can dictate the impact of CGT and how much of it they incur. Let’s consider numerous investing time frames to compare the impacts of CGT:
Short term approach
A short-term approach (under 1 year) to property investing is where CGT hits hardest. Short-term investing can sometimes be referred to as “flipping”. Flipping is an investment strategy where an investor holds an asset for a short period of time and then sells quickly for a profit. This strategy would work extremely well for property investors. This is because properties can be bought under market value, have the ability to manufacture equity, and have an emotional appeal to them. So, an educated investor would have the ability to make money on the way in, build in equity, and sell for a profit quite quickly. Unfortunately for those investors stamp duty and CGT knockdown profits quite significantly. This is likely why there are more long-term investors in the market as short-term gains can be eroded by the numerous taxes from the government including CGT.
Medium Term approach
A medium-term approach (1-5 years) may prove to be more effective than the rest. This is a bold statement to make considering the impact of CGT as discussed. However, considering this, we know that property tends to work in cycles. That means each market has a peak and trough over time. So, to outperform the market an investor needs to purchase in a high-demand area that is primed for growth in the short-term (next few years). In doing so they can take advantage of the gains within that area with minimal stagnant growth. So, what if the investor continued to buy at the bottom of the market and sold at the top?
Buying and selling through to peak would likely outperform a buy and hold strategy. That is to say, if you buy an asset primed for growth, incur the costs of CGT, and repeat you may end up with a greater return over the long term. This may be something to consider when determining your investing approach.
Long term approach
Taking a longer-term approach (5+ years) to property can minimise the blow of CGT. Property is inherently an illiquid asset meaning it costs time and money to buy in and out of a property. Therefore, many investors have a buy-and-hold strategy when investing in property. Particularly as the fruits of this investment vehicle are largely seen over years not days or weeks. This does mitigate the impact of CGT to a lesser extent. Though, it means if the investor chooses to sell at some stage, they will likely face a hefty CGT.
Capital gains tax is an unfortunate cost of making a profit within investing. The implications of this tax can have a significant impact on property investors. in fact, it doesn’t matter what investment class you invest in, if you made a capital gain, you are likely required to make a tax payment. So, it is important to understand how CGT works in order to determine whether you will be liable to pay additional tax should you make a capital gain selling an asset.