The absolute beginner’s guide to capital gains tax for property investors- Part 1

If you’re like many investors who adopt a buy and hold and never sell strategy, capital gains tax (CGT) may not be your immediate concern. That’s because unlike your annual tax obligation, CGT is not something you deal with every year. In fact, if you have never sold any property, chances are capital gains tax simply has not made it onto your radar as an issue with which you need to contend. Even so, knowledge is power - being aware of and understanding how capital gains tax work may very well help you save tax down the track. Eddie Chung explains the nitty gritty this important tax concept.

What is CGT?

CGT may arise when you sell a ‘CGT asset’, which includes, inter alia, an investment property. However, bear in mind that other assets such as a share portfolio or intangible assets such as a contractual right is also a CGT asset. While the disposal of a CGT asset may give rise to capital gains tax, there are other ‘CGT events’ that do not necessarily involve selling a CGT asset that will also have CGT implications. For example if you:
  • Surrender a right you own
  • Create a trust over an asset
  • Destroy an asset that you own and so on
These are example of CGT events that could also give rise to a capital gain or capital loss. However, certain assets are specifically exempt from CGT (eg, a motor vehicle), while the capital gain derived or capital loss incurred on certain assets is specifically disregarded (eg, a CGT asset you acquired on or before 19 September 1985).
Selling an investment property doesn’t always result in capital gain or capital loss
The sale of an investment property will trigger the happening of a CGT event but that does not always mean that a capital gain or a capital loss would arise.
If the property is held on ‘revenue account’ rather than ‘capital account’, then any gain you make from the sale of the property will effectively be taxed as ‘income’, rather than a ‘capital gain’. A property is held on revenue account if you acquired it with the intention of developing it for resale to realise a profit, whether it is on a one-off or recurring basis. This is in contrast to the situation where you bought the property for the purpose of deriving rental income over the medium to longer term as a capital asset. In more complicated situations, it is possible for a property to be bought as a capital asset but you subsequently change its purpose and convert it from being a capital asset to a revenue asset. The vice versa situation may also arise to convert a property from being a revenue asset to a capital asset.

Who is liable and which assets are subject to CGT?

Australian residents
If you are a tax resident of Australia, you are generally liable to Australian CGT on any CGT asset you own worldwide, eg, an investment property located overseas. This default position may be modified by any Double Tax Agreement (DTA) Australia may have with the country in which the CGT asset is located outside of Australia.
The DTAs between Australia and other countries generally allows the country in which an investment property is physically located to tax the gain but do not restrict the other country from also taxing the gain.
This essentially means that both countries may tax the capital gain but the country of which the taxpayer is a resident would usually allow the taxpayer to claim a foreign tax credit on all or part of the tax paid in the foreign jurisdiction on the same capital gain. The same applies under the domestic law in Australia if the DTA does not provide for a foreign tax credit or if Australia does not have a DTA with the country in which the investment property is located.
Non-residents or temporary residents
If you are a non-resident or temporary resident for Australian tax purposes, you are only liable to Australian CGT on any Taxable Australian Property you own, which is usually limited to Australian real estate, shares or units in certain companies and trusts that predominantly own Australian real estate, and certain mining, quarrying, and prospecting rights in Australia.
Assets that are not Taxable Australian Property owned by a non-resident or temporary resident are generally not caught by the Australian CGT rules.

How is capital gains tax calculated?

One of the downsides of investing in property is paying capital gains tax when you sell. So how is it calculated and how can you reduce your tax bills without getting in trouble with the tax man?

Capital gain

The capital gain on the sale of a property is generally calculated by subtracting the ‘cost base’ of the property from the ‘capital proceeds’ (usually the sale price) on the sale of the property. Therefore, the higher is the cost base of the property, the lower is the capital gain. Some capital gains are eligible for the CGT discount while others are not (refer to the paragraph under the heading ‘CGT discount’ below). All the capital gains that are eligible for the CGT discount in an income year are aggregated (‘aggregated discountable capital gains’) and all the capital gains that are ineligible for the CGT discount are also aggregated (‘aggregated non-discountable capital gains’). If the relevant entity has carried forward or current year capital losses, it may choose to use the capital losses to reduce the aggregated discountable capital gains and/or aggregated non-discountable capital gains at its discretion.
If the entity chooses to apply capital losses against the aggregated discountable capital gains first, the reduction of the aggregated discountable capital gains will result in a lower CGT discount for the entity.
Given this requirement, it is generally more tax beneficial to apply the capital losses against the aggregated non-discountable capital gains first before any remaining capital losses are applied against the aggregated discountable capital gains. All the remaining aggregated discount capital gain and aggregated non-discountable capital gains are added together to arrive at the ‘net capital gain’. To calculate the CGT on the sale of an investment property, the net capital gain will need to be calculated and added to the assessable income of the entity that owns the property. The entity will then reduce its total assessable income by any allowable deductions it has to arrive at its taxable income. The taxable income will then be subject to tax based on the tax rates that are applicable to the type of entity concerned. For instance, if you sell an investment property that you own as an individual, the net capital gain on the sale of the property is added to your assessable income. The assessable income is reduced by any allowable deductions to which you are entitled to arrive at your taxable income, which is subject to tax at your marginal tax rates. If your investment property is owned by a company, the net capital gain is included in the company’s taxable income, which is subject at the corporate tax rate (generally 30% unless the company is a ‘small business entity’).

How it works in real life

To illustrate how these rules operate, consider the following example: You as an individual sold two investment properties in the same income year. The capital gain on Property 1 that is eligible for the 50% CGT discount is $400,000. The capital gain on Property 2 that is not eligible for any CGT discount is $300,000. You have carried forward capital losses of $500,000 and also incurred a current year capital loss of $50,000. Your net capital gain will be calculated as follows: Aggregated discountable capital gain = $400,000 Aggregated non-discountable capital gain = $300,000 Total carried forward and current year capital losses = $500,000 + $50,000 = $550,000 Net capital gain = ($300,000 - $300,000 of total capital losses) + [($400,000 - $250,000 of remaining total capital losses) x 50% discount] = $75,000 The $75,000 is added to your assessable income that is then reduced by any allowable deductions to which you may be entitled to arrive at your taxable income. Your tax liability for the year will then be calculated on the taxable income based on your marginal tax rates.

Cost base

The cost base of a property includes a number of elements, which include:
  • The original purchase price of the property
  • The incidental costs on both the purchase and sale of the property (eg, stamp duty, legal costs, etc)
  • Capital expenditure to improve the property’s value
  • Costs to preserve or defend your title to the property
Further, provided that the property was acquired after 20 August 1991, certain costs (known as the ‘third element’ of the cost base) that would ordinarily be revenue in nature but cannot be claimed as a tax deduction are also included in the cost base, including interest on money you borrowed to acquire the property, costs of maintaining, repairing, or insuring the property, rates or land tax, etc. For instance, if the investment property was not available for rent for part of the ownership period, these expenses would have been tax-deductible, which means that they can be included in the cost base of the property. However, the cost base must also be reduced by the cumulative capital works deduction amounts that you have claimed or have been entitled to claim if you acquired the property on or after 13 May 1997.
In part 2, Eddie Chung discusses capital gains exemptions and how you can maximise your tax savings.

Do you have a burning tax question?

Send me your questions and I’ll get our tax experts to clarify any issues you may have regarding capital gains tax or any other property investment-related tax concerns. Email: nila@propertymarketinsider.com.au You can also post your questions in our Facebook page: https://www.facebook.com/propertymarketinsider.com.au/
Article by: Eddie Chung, Partner, Tax and Advisory, Real Estate & Construction, BDO (QLD) Pty. Email: eddie.chung@bdo.com.au
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person.  This article is provided on the terms and understanding that the author and BDO (QLD) Pty Ltd are not responsible for the results of any actions taken on the basis of information in this article, nor for any error in or omission from this article.  The article is provided for general information only and the author and BDO (QLD) Pty Ltd are not engaged to render professional advice or services through this article.  The author and BDO (QLD) Pty Ltd expressly disclaim all and any liability and responsibility to any person in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this article.    

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