A guide to capital gains tax – what’s changing and how are property investors affected?
Along with negative gearing, Labor’s proposed change to capital gains tax has been a key point of contention ahead of this year’s Federal Election.
But if you look past the political spin and media headlines, what’s really likely to change and how might this impact your investments?
What is capital gains tax?
A capital gain is the profit made from buying and selling an asset, such as property or shares.
Capital gains tax (CGT) is the tax you pay on the capital gain that you made from the sale. (Capital gains tax is only payable when the asset is sold.)
If you make a capital loss from the sale of an asset, you can carry this loss forward indefinitely and offset it against any capital gains.
According to the ATO, most personal assets are exempt from CGT, including your home, car and personal use assets such as furniture.
CGT also doesn’t apply to depreciating assets used solely for taxable purposes, such as business equipment or fittings in a rental property.
How much is capital gains tax?
Despite its name, CGT is not a separate tax, it forms part of your income tax.
If you buy and sell your investment property within 12 months, you get taxed on your profit at your marginal income tax rate.
As a simplistic example: John has a taxable income of $80,000 a year. He buys an investment property for $500,000 in July 2018 and sells it just a few months later for $550,000. John’s new taxable income for FY2018 is $130,000 ($80,000 + $50,000).
However, if you hold your property for more than 12 months, the profit you make when you sell your investment property is typically taxed at only half the rate of other income.
For example, John has a taxable income of $80,000 a year. He buys an investment property for $500,000 in July 2018 and sells it in 2020 for $550,000. Being eligible for the CGT 50% discount, John’s taxable income for FY2020 is only $105,000 ($80,000 + $25,000).
This 50% discount on capital gains was introduced back in 1999, to replace the former, more complicated ‘indexation’ method. This taxation advantage for future capital gains adds to the appeal of residential property investment for many Australians.
What are the proposed changes to capital gains tax?
If elected, the Labor party has plans to halve the capital gains discount for all properties purchased after a yet-to-be-determined date after the next election. In effect, this will reduce the capital gains tax discount for properties that are held longer than 12 months from 50% to 25%.
So, as per the second example above, John would have a taxable income of $117,500 ($80,000 + $37,500) instead of $105,000 ($80,000 + $25,000) if the proposed changes go through.
If you sell your investment property in less than 12 months, you’ll continue to pay the full capital gains tax – ie no change to what’s currently in place.
Any changes will be grandfathered, which means they won’t apply to any properties purchased before Labor puts its changes into effect.
What’s really going to change?
These changes, along with negative gearing reforms have been proposed to tackle the issue of housing affordability – which has been a major issue, particularly in Sydney and Melbourne. However, critics warn that it may have the opposite effect, and public sentiment about Labor’s housing tax changes have been wavering.
According to Goldman Sachs economists, if they are passed, Labor’s proposed negative gearing and capital gains tax reforms will in reality only have a small effect on individual investments, and residential property will remain attractive. There is also doubt as to whether Labor will be able to pass the changes if elected.
“We are also somewhat sceptical of the ability of the ALP to pass changes to the capital gains tax arrangements through the Senate given the likely make-up of the cross-bench – which in our view is the most impactful aspect of the reform package (as opposed to the changes to ‘negative gearing’).” – Goldman Sachs, ‘Fear vs Fundamentals’
Goldman Sachs says Labor’s proposed negative gearing and capital gains tax reforms will only have a small effect on individual investments, and residential property will remain attractive.
Regardless of whether or not the reforms go through, it’s important to note that investors still make up only a small minority of Australian taxpayers.
Further, many property investors in Australia, use residential property as a means of saving for retirement – providing an ongoing supply of rental properties, and creating many self-funded retirees, who do not expect help from the government.
As CGT is only payable if you sell your asset, for long-term investors, any changes to the discount will have no immediate application. Investors also don’t need to sell their property to realise gains – they can simply refinance and use their equity to build their portfolio further.
“If the changes were to be implemented, it is anticipated a proportion of investors will elect to hold investments for longer periods of time, or even elect not to sell,” said Ironfish Head of Property, William Mitchell.
If these changes do pass, and investors do need to sell, their future capital gains will continue to be preferentially taxed to other income, albeit with a smaller discount.
Whichever way the penny falls in the upcoming election, at Ironfish we continue to advocate a long-term buy and hold strategy, and to ensure you build a diverse portfolio of quality properties, with strong owner-occupier appeal in great locations.
While the market will always fluctuate over the short term, and policy changes will come and go, we expect long-term demand for good properties in the right locations to remain strong.
We hope this blog has given you a better understanding of the general concept of capital gains and CGT. But if you would like more information about these or other taxation matters, please seek advice from your qualified finance professional. We are happy to provide some recommendations of finance professionals if you need – just drop us a line.