A great way to minimise possible ‘angst’ over capital gains tax is to be aware of all the tax exemptions and concessions that the Australian Taxation Office (ATO) makes available to homeowners and property investors. With this in mind, we’ve put together this article to guide you in understanding capital gains tax, when you’re liable to pay it and the steps you can take to reduce – or even avoid – capital gains tax liability at the time of selling your property.
What is Capital Gains Tax and how does it work?
When you sell certain types of property, including real estate, the difference between how much you paid for it and how much you sold it for is known as capital gains (or potentially capital loss) and this may have tax implications for you.
For instance, according to the ATO, if you profit from the sale of an investment property, that profit is considered a capital gain and must be declared on your income tax return.
The tax you have to pay on a capital gain is commonly known as capital gains tax or CGT, although it is technically part of your income tax, rather than a separate tax.
Who pays Capital Gains Tax?
Generally, once a CGT event occurs (i.e. when you sell your property), the seller is liable to pay capital gains tax on the profit generated from that sale.
However, capital gains tax is not limited to the sale of land and property. You may also be liable to pay CGT if you’re selling any of the following:
- units in a trust
- your stake in a managed investment fund
- shares in a company
- contractual rights that your business has
What are Capital Gains Tax exemptions?
Fortunately, the ATO allows property owners to avoid capital gains tax liability altogether if they fall into one of the CGT exemption categories. These include:
Principal Place of Residence exemption
As a general rule, if you own property simply to live in as your own home or your family home, that property will be your principal place of residence.
This exemption exists because you don’t generate an income from living in your own home. So, you won’t need to declare any profit on the sale of your home on your annual income tax return.
There are, however, certain eligibility criteria that you have to meet to satisfy the ATO’s primary place of residence exemption:
- you must live in the property for the whole time you own it
- you must generally keep your possessions at the property
- you must use the address to receive your postal mail
- all the property’s utility accounts must be in your name
The Capital Gains Tax six-year rule
According to the capital gains tax property six-year rule, you can use your home as an investment property for up to six years, and the ATO may still treat it as if it were your PPOR for capital gains tax purposes.
If you sold your investment property within those six years after you began living elsewhere, then depending on your other circumstances your property could still be considered your PPOR for tax purposes, and you wouldn’t necessarily be liable to pay capital gains tax.
So, just like a homeowner who can sell their family home without having to pay capital gains tax, a property investor can often also sell their property and not have to pay CGT.
The Capital Gains Tax six-month rule
The Capital Gains Tax six-month rule is when the ATO allows you to hold two PPOR at the same time if you acquire your new home before disposing of the old one. If that is the case, both properties will be treated as your PPOR for up to six months.
Outside of property, the ATO explains that you generally don’t have to pay tax when you sell a car or motorbike, while depreciating assets used for business purposes (such as fittings in a rental property you own) are also exempt.
Can you reduce Capital Gains Tax if you aren’t exempt?
Yes, there are certain CGT discounts or partial exemptions that may be available even if you cannot claim a full exemption, such as if the property you’re selling is not considered your PPOR or if part of the property is used to produce income (such as running a business or renting out a room).
One of these partial exemptions allows you to claim a 50% discount on your capital gains tax if you have owned the property for at least 12 months before selling it.
How much is Capital Gains Tax?
To determine how much capital gains tax you’ll be liable for following a CGT event, you’ll need to calculate it using one of these two primary methods:
Before delving into the calculation methods, it’s worth understanding how to calculate your capital proceeds:
Asset sale price – cost base = capital proceeds
The cost base = purchase price + expenses (see below) – (grants + depreciation).
In other words, generally the capital proceeds from selling a house are the profit you make from the sale, after subtracting what you spent to buy and maintain it over the years.
Cost base expenses
As part of calculating their capital gains, the expenses that investors can add to a cost base include, but are not limited to:
- Incidental costs, such as rental advertisement fees, legal fees and stamp duty
- Ownership costs, such as those incurred when searching for and inspecting properties
- Title costs, such as the legal fees incurred when registering your property’s title to the Land Titles Office in your state or territory
- Improvement costs, should you decide to replace the flooring or install a deck, for example.
The best way to determine what expenses investors can add to their cost base and how they can reduce the amount of capital gains they declare would be to have a quantity surveyor draw up a Capital Gains Reduction Report.
The process of obtaining a Capital Gains Report essentially helps streamline the reduction process by factoring in all capital expenses for a property.
Detailing these expenses will give investors an accurate picture of the property’s cost base’s total value, which will ultimately help reduce the amount of CGT payable.
The CGT discount method
You’ll use this method to calculate your capital gains tax liability if you’ve held your property or business asset for 12 months and qualify for the 50% discount. Your calculation would look like this:
Capital Gains Discount Calculation for Individuals
Capital Proceeds x 50% = Capital Gain
So, if your capital proceeds amounted to $48,000 at the CGT event and you’d held the property for two years, you could apply the 50% CGT deduction and only pay CGT on $24,000: $48,000 x 50% = $24,000. In other words, the capital proceeds you’ll declare in your income return will be $24,000 instead of $48,000.
The indexation method
If your property or business asset was purchased before 21 September, 1999, you could increase the cost base by an indexation factor. You’ll essentially be adjusting the cost base to avoid paying capital gains tax on the portion subject to inflation. You can choose to use either this method or the discount method to calculate capital gains tax.
The calculation works as follows:
Calculation of Indexation Factor
Consumer Price Index (CPI) for Quarter of CGT Event ÷ Consumer Price Index for Quarter when Expenditure Occurred = Indexation Factor
Note: An indexation factor is applied to each element of your cost base. Then you’ll multiply your capital proceeds by the indexation factor to calculate your capital gain:
Capital Proceeds x Indexation Factor = Capital Gain
The ATO offers a helpful capital gain or loss worksheet that lets you calculate using both methods to see which outcome may be better for you.
The ‘other’ method
According to the ATO, this is the simplest of the three methods. This method is typically used to calculate your capital gain where you’ve bought and sold an asset within 12 months.
You’ll simply subtract your cost base from your capital proceeds; and the amount of proceeds left is your capital gain.
If you are selling a property, you should be aware that any profit made from the sale is potentially considered a capital gain, so may be subject to capital gains tax.
However, if you want to take advantage of the exemptions and concessions available, here are some tips:
- make sure that your property remains your primary place of residence
- utilise the six-month rule if you’ve bought a new home but haven’t sold your old property
- don’t vacate your PPOR for more than six years and then decide to sell it – sell it within six years
- consult with a qualified tax agent, such as a professional at Duo Tax, to get your hands on a Capital Gains Reduction Report, as this could significantly reduce your cost base and ultimately reduce your CGT liability.
→ Related: Visit Canstar’s Tax Hub
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