Capital gains tax is an area of taxation that often confuses property investors. The legislation can appear complex, however it’s important for all investors to have a good understanding of it before selling an asset.
Capital gains tax is the fee you pay on any profit made from the sale of an investment property. This profit is referred to as a capital gain and is the difference between what you paid for the property (your cost base) and what you sold it for. It’s included in your assessable income and taxed at your marginal rate.
In this article, we will cover:
- When do you pay capital gains tax on investment property?
- How to calculate capital gains tax
- Capital gains tax methods
- Capital gains tax exemptions
- Depreciation and capital gains tax
When do you pay capital gains tax on investment property?
A capital gains tax (CGT) event occurs when an asset is sold. The timing of this is important as it determines the income year the tax will be applied. For property investors, a CGT event is triggered when you enter into a contract of sale and therefore stop being the owner of the property. The CGT is then applied in the same financial year you sold your property.
It’s important to keep thorough records of this process so you can correctly calculate the amount of capital gain or capital loss you make. Property investors are required to keep these records for five years after the CGT event occurs.
This is particularly important when you make a capital loss, as the amount can be carried forward as part of unapplied net capital losses. A capital loss does not reduce a taxpayer’s assessable income. Instead, taxpayers are able to offset the loss against a capital gain in the current or future financial years.
How to calculate capital gains tax
A basic formula for calculating CGT is:
Selling price – transaction costs – original purchase price + associated transaction costs = capital gain (or loss)
If you have bought and sold an investment property within 12 months, your net capital gain will be added to your taxable income for that year. However, if you have owned an investment property for more than 12 months, there are two methods to calculate your net capital gain – discount and indexation. Depending on eligibility, you can choose whichever method reduces your capital gain the most.
Capital gains tax discount method
Property investor who have owned an investment property for more than 12 months are entitled to specific concessions when calculating CGT. If you’re an Australian resident and have held the property for more than one year, you’re eligible for a 50 per cent discount on your net capital gain. This reduces your assessable income and therefore the amount of tax you will pay.
Capital gains tax Indexation method
If you are an Australian resident who purchased an investment property before 21st September 1999, you are eligible to use the indexation method. The indexation method accounts for inflation and therefore calculates your net capital gain based on what your property would be worth in today’s property market. The calculation divides the consumer price index (CPI) at the time you sold your property by the CPI at the time you bought the property. As a result, your initial purchase price is likely to be increased, and your capital gain reduced.
Capital gains tax exemptions
There are certain circumstances in which CGT can be exempt. CGT exemptions include 50 per cent discount, principal place of residence, six year rule and six month rule.
50 per cent rule: As previously mentioned, property investor who have owned an investment property for more than 12 months are entitled to a 50 per cent discount on CGT.
Primary place of residence: This refers to when a person resides, occupies and lives in a property as their home. If a property is considered an owner’s primary place of residence, they are entitled to a full CGT exemption.
Six year rule: If a property owner moves out of a primary place of residence and rents it out, they can claim an exemption from CGT for a period of up to six years. If a property owner moves back into the property and afterwards moves out again then a new six year period commences from the time they last moved out.
Six month rule: There are exemptions from CGT if a property owner considers more than one property to be a primary place of residence within a six month period. The property owner must meet one of the below conditions:
- The old property was the owner’s primary residence for a period of at least three months in the twelve months before they sold it
- An owner did not use the property to provide assessable income in any part of the twelve months prior to selling
Depreciation and capital gains tax
Capital gain is your profit minus your cost base. Depreciation impacts your cost base and therefore affects CGT. Depreciation deductions can be claimed under two categories – plant and equipment deductions and capital works depreciation. Both can affect your cost base in different ways.
To find out more, read Does Depreciation Affect Capital Gains Tax?