How capital gains tax is calculated?

They say the only two certainties in life are death and taxes. If you’re an Australian who owns an investment property, a home that has been rented out, or a share portfolio and you plan to sell your asset in the future, then there’s a very good chance you will be liable to pay capital gains tax. Depending on the value of your asset and whether you make a profit when you sell it, you could end up owing the tax office tens of thousands or even hundreds of thousands of dollars.

With so much at stake, it pays to fully understand the ins and outs of capital gains tax (CGT). Knowledge of the rules that determine how it is calculated could help you to reduce the amount of tax you pay, allowing you keep as much as your profit as possible.

So what are capital gains? And how are they taxed?

Basically, If you buy an asset for one price and sell it later for a higher price, the difference between the two prices minus any costs is a capital gain or a profit. If, on the other hand, you end up selling the asset for less than you paid for it, you’ve experienced a capital loss.

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If you are an individual who makes a capital gain on an asset acquired after 20 September 1985, you are typically liable to pay capital gains tax. The profit you have made on the sale is added to the other income you make in the year of (such as salary and wages) and taxed at the appropriate marginal rate.

However, there are a range of circumstances and various regulations that can affect whether an asset sale is exempt from capital gains tax or whether a discount applies. For example, assets such as your family home, car, furniture and other belongings are generally not subject to capital gains tax if you sell them. The length of time an asset has been held before sale also has an impact, as does the proportion of time a property has been used as your primary residence.

It’s important to note that capital gains tax is not payable until an asset is actually disposed of.

Capital gains tax on long-term gains

One of the biggest factors in determining how much capital gains tax is payable is the length of time an asset has been held by an individual before it is sold. Gains which are realised by an individual after an asset has been held at least 12 months (long-term gains) typically qualify for a 50 per cent discount.

So, if you buy an investment property for $500,000 and sell it after two years for $600,000, you have made a capital gain of $100,000. Because a 50 per cent discount applies to gains realised more than 12 months after purchase, the taxable component of the gain is reduced to $50,000. If your taxable income from other sources is $90,000 in the year of the sale, you would pay a tax of 37 cents in the dollar on the capital gain component, or $18,500. (Figures based on 2019/20 tax rates.)

If you have recorded a capital loss from another sale in the same year as a capital gain, the loss may be subtracted from the gain to arrive at an overall lower figure, reducing or eliminating your capital gains tax liability.

A slightly different approach, ‘the indexation method’, may be used to calculate the capital gains tax on assets acquired before 21 September 1999.

Capital gains tax on short-term gains

If you are forced or want to sell an asset within a 12 months of having acquired it, you are not entitled to a discount on the capital gains tax. In this case, what the ATO calls ‘the other method’ applies in calculating your tax liability. Essentially this involves subtracting your cost base (what it cost to buy and sell the asset) from the capital proceeds (the sale price)  to arrive at the taxable amount. The ATO gives the example of a woman who bought a property for $250,000 and sold it within 12 months for $315,000. Her total costs including the sale price, stamp duty, agent’s commissions and solicitor’s fees were $262,500. Subtracting $262,000 from $315,000 produces her taxable capital gain of $52,500.

How is capital gains tax calculated in different Australian states?

While capital gains tax is often thought of a separate tax, it is essentially part of income tax. It is levied by the Commonwealth Government and as such is unaffected by the laws of the various states in which a property might be sold.

People sometimes mistake capital gains taxes with the stamp duties levied by various states and territories when selling a property. These can vary widely according to which part of Australia you live.

Stages of property – rental

One of the more complicated aspects of capital gains tax is determining how much tax is payable when the family home has been rented out for a period of time. As a general rule, an individual’s primary place of residence is not liable to capital gains tax when it is sold.

But what happens if a property is first your home and then becomes a rental property? Or vice versa?

An exemption known as the ‘six year rule’ may apply. Under the rule, a property that was initially your primary residence may be rented out for a period of up to six years and still be exempt from capital gains tax. The exemption applies only where no other property is nominated as an individual’s primary place of residence. If the owner of the property moves back in for a period and then moves out, the six year period re-sets from the time they last moved out.

If a property was initially a rental property and later became your primary residence, you cannot claim a full capital gains tax exemption at sales time. However, you may claim a partial exemption based on the time the property was your primary residence.

Stages of property – sale

Regardless of how much an asset appreciates in value over time, the owner is not liable to pay capital gains tax until it is actually sold. Once the sale occurs, the relevant method should be used to calculate capital gains tax liability.

Remember these simple guidelines. Your family home (principal place of residences) is not typically liable for CGT when sold. If you sell an investment property or other asset within 12 months of acquiring it, you will likely be liable for the full rate of capital gains tax. However, if you sell after 12 months, you are likely to qualify for a 50 per cent discount on your liability.

Investment property

The term ‘investment property’ usually refers to a piece of real estate that is distinct and separate from the family home or a person’s primary place of residence. It is bought with a view to make money from either rental income or future resale. As such, typical investment properties are not exempt from capital gains tax at sale time.

If the property is bought and re-sold by an individual within a 12-month period, the entire capital gain will be subject to taxation when the owner completes their yearly tax return. In cases where the property has been owned for more than 12 months at the time of sale, a 50 per cent discount generally applies.

Inherited property

In cases where a person dies and leaves a property or other asset to beneficiaries, those beneficiaries are not immediately liable to pay capital gains tax. However, capital gains tax may be payable should the beneficiary later sell the asset.

If the property in question is sold by the beneficiary within two years of the original owner dying and the property was the primary residence of the deceased or was purchased before September 1985, then capital gains tax is not payable.

However, if the property is sold more than two years after the original owner’s death and the beneficiary has not made it his or her primary residence, then capital gains tax is typically payable. The amount of tax is based upon the increase in property value from the time of the deceased’s death up until sale time. (If the beneficiary makes the property their main residence, no capital gains tax is payable upon sale.)

Frequently Asked Questions

Are capital gains taxed twice?

No. You will only pay tax on a capital gain once, at the end of the year in which the asset in question was sold. However, if you sell multiple assets in a year and make a capital gain or each, you will incur capital gains tax on all the sales.

How do I avoid capital gains on property?

In some circumstances you can reduce or avoid paying capital gains tax. If you hold onto an asset for more than a year before making a capital gain, you qualify for a 50 per cent CGT reduction. If a property is your primary residence it is not subject to CGT. Even if a property that was your primary residence has been rented out for up to six years, you may still be able to claim an exemption.

What is the income threshold for capital gains tax?

While many people consider it a separate tax, capital gains tax is essentially a form of income tax. The profits an individual makes through the sale of an asset contribute to his or her overall taxable income for the year in which the sale was made. As such, the amount of your tax you pay on your capital gain will depend on your other income sources and the top marginal tax rate you reach.