How is Capital Gains Tax calculated?

Expert Advice with Ken Raiss.

Capital Gains Tax (CGT) is one of those things that most investors know they will probably have to pay one day – and then promptly forget out it!

The reality is that CGT can be difficult and confusing to understand, let alone calculate, so it’s important to have specialists on your side – and especially a good taxation accountant.

Following on from the article where I explained what Capital Gains Tax is and what it isn’t, today I will outline what are CGT costs as well as how it is calculated.

When do you have to pay CGT?

It’s important to remember that CGT is payable in the tax year in which you sell or dispose of your assets, such as a rental property.

That’s why it’s vital to understand the timing of any capital gains and capital losses especially when there are multiple assets being considered for sale and where different outcomes are expected.

For example, if you sell an asset with a capital gain in one year you pay the CGT that year even if you generated a capital loss in a subsequent year.

On the other hand, capital losses are carried forward.

This means that if you are able to manage the timing of your sale of various investment assets, it is usually better to sell those assets which generate capital losses first so that any subsequent capital gains are reduced by the previous capital loss.

Also, if you follow a long-term wealth accumulation strategy you won’t really need to worry about paying CGT for many years or possibly even decades – either from a sale by the original owner or a subsequent owner if handed down on death.

Remember that when you sell an investment property, it is called a CGT event.

And your capital gain is the difference between your net capital proceeds and the cost base of your CGT asset – that is, you received more for the investment asset than it cost you.

What is a cost base?

Not to get too stuck into the nitty-gritty but the cost base for calculating the CGT of an asset is what you paid for it, together with many of the costs associated with acquiring it.  

For an investment property the cost base will likely include:

•    The property purchase price;

•    Stamp duty;

•    Buyers’ agent fees;

•    Some specific investigation and/or due diligence costs on the property purchase inspection costs;

•    Legal fees;

•    Renovation costs and

•    Certain bank fees plus other applicable costs.

On the other side of the equation, when you sell your asset, the net proceeds are the sale price you achieve less agent fees, legal fees, presentation costs, advertising, some bank and finance expenses plus other applicable costs.

Also, for rental properties, you will also need to adjust the cost base by adding back any building depreciation previously claimed. Now that’s something many investors don’t realise.

As you can see, CGT can be quite tricky to get your head around so it’s important to work with a professional because you’ll find that there are even different rules depending on when you bought your property.

You see, if the rental property or asset was acquired before 20th September 1985, which was pre the CGT legislation, then no CGT is payable by you when you sell it.

However, any major improvements you made to your property since that time may be subject to CGT.

Plus, if a pre CGT assets is passed on after death it will be subject to CGT on a subsequent sale.

So, how is CGT calculated?

Hopefully, you now have a better understanding of the costs and expenses that are considered when you sell an investment property that is subject to CGT.

Now, it’s time to understand that there are two principal methods to calculate the tax payable on a Capital Gain.

And what’s quite cool is that investors can use the method that gives them the best tax result – that is, the smallest tax on the capital gain.

Method 1- CGT Discount Method

You can use this method to calculate your capital gain if:

•    You're an individual, trust or complying super fund

•    The capital gain tax (CGT) event happened to your asset after 11.45am (by legal time in the ACT) on 21 September 1999

•    You acquired the asset at least 12 months before the CGT event

•    You did not choose to use the indexation method (Method 2).

Under this method the capital gains are discounted by 50% and this sum is then added to the taxpayer’s taxable income and then the normal marginal tax rates are applied to their total income.

In other words, there is no specific tax rate on a Capital Gain – you just pay tax on your total income for the year of which the Capital Gain you made is part of.

However the 50% discount doesn’t apply to companies. It only applies to individuals if they received the gain directly or from distributions received from a trust which sold the asset.

To complicate matters further, there are some exceptions to the requirement that you must have owned an asset for at least 12 months for the discount method to apply. These may include marriage or relationship breakdowns approved by the courts and/or as a beneficiary of a deceased estate.

If the asset was not held for 12 months, you are not entitled to the 50 per cent CGT discount, so clearly holding on for another two days is probably worth your while as long as you haven’t done so for tax avoidance purposes.

Method 2 - Indexation Method

You can use this method to calculate your capital gain if:

•    A CGT event happened to an asset you acquired before 11.45am (by legal time in the ACT) on 21 September 1999, and

•    You owned the asset for 12 months or more.

The indexation method increases the purchase costs by using an indexation factor to account for inflation between the date of purchase and the date of selling the asset.

ATO supplies a new indexation factor each quarter.

These inflated purchase costs are then used to determine the cost base to calculate the Capital Gain on sale. The 50% discount does not apply if the indexation method is used.

If you're not a company and you meet the two conditions above and want to use the indexation method, you must choose to do so, otherwise the discount method will apply.

The 12-month requirement exemptions are the same as those identified above for the discount method.

To determine whether you acquired the asset at least 12 months before the CGT event, you need to exclude both the day of acquisition and the day of the CGT event.

Choosing a Method

The best method to use depends on a range of factors: the type of asset you own, the dates you owned it, past rates of inflation and whether you have any capital losses available.

The decision on which method is entirely up to the taxpayer. Many people do the Capital Gains calculation using both methods and then they choose the method that has the lowest CGT.

Quite simply, the way you prepare your tax return is sufficient evidence of the choice.

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Ken Raiss is director of Metropole Wealth Advisory and gives independent expert advice for property investors, professionals and business owners. He is passionate about real estate investing and small business and is a regular commentator for Michael Yardney's Property Update.

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Disclaimer: while due care is taken, the viewpoints expressed by contributors do not necessarily reflect the opinions of Your Investment Property.