Capital gains tax (CGT) is the tax you pay on profits from selling assets, such as property.
You essentially make a capital gain when the difference between the cost of purchasing your property (or another asset) and what you gained from selling it is greater than zero - in other words, you made a profit.
If you received less than the cost base of your assets, then you made a capital loss.
You report your capital gains and capital losses in your income tax return and in most circumstances, need to pay tax on your capital gains.
Interestingly although it is referred to as 'capital gains tax', it's actually part of your income tax - not a separate tax.
The good news is that this tax does not apply to your own home, known as your principal place of residence.
So, in this article, we'll outline what CGT is, how to legally minimise your Capital Gains Tax obligation, and how to go about calculating Capital Gains Tax so there are no surprises when the taxman (or woman) comes calling.
How does Capital Gains Tax work?
Capital Gains Tax or CGT is one of those taxes no one really wants to pay.
CGT was introduced in Australia in 1985 and applies to any asset you've acquired after that time unless specifically exempted.
If you ask me, CGT is the last throw of the dice the tax department has to reduce your family’s wealth.
That’s because the more capital gains you have made, due to either a good investment or through a long-term holding, the more tax that will be applied if you sell your asset.
Annoyingly, even after your death, your beneficiaries will be taxed on investments you have made that they subsequently sell.
You see, the Australian Taxation Office (ATO) is very patient and is prepared to wait many years or even decades for its last throw of the dice!
In fact, this tax may even be applied in certain circumstances without an asset sale, such as leaving your children an inheritance on your death either as a superannuation payment (not exactly CGT but a tax nevertheless) or if they are living overseas at the time of your death, depending on the assets.
But in general, as I mentioned, a capital gain or capital loss on an asset is the difference between what it cost you and what you receive when you dispose of it.
You then pay tax on your capital gains, but not a separate tax by itself.
Instead, the capital gain you make is added to your assessable income in whatever year you sold the property (or asset.)
Even though it forms part of your income tax and is not considered a separate tax – it is still referred to as CGT.
But if an asset is held for at least one year, then any gain is first discounted by 50% for individual taxpayers or by 33.3% for superannuation funds.
However, if the asset is owned by a company, the company is not entitled to any CGT discount, and you'll pay a 30% tax on any net capital gains.
And for an SMSF, the tax rate is 15% and the discount is 33.3% (rather than 50% for individuals).
What is a Capital Gains Tax event?
CGT event is the date you sell or dispose of an asset.
If there is a contract of sale, the CGT event happens when you enter into the contract.
For example, if you sell a house, the CGT event happens on the date of the contract, not when you eventually settle.
If there is no contract of sale, the CGT event is usually when you stop being the asset's owner.
For example, if you sell shares, the CGT event happens on the date of sale.
Offsetting capital gains with losses
Capital losses can be offset against capital gains, and if you don’t have a capital gain to offset the loss in a particular tax year, your net capital losses may be carried forward indefinitely.
However, capital losses cannot be offset against normal income.
According to the ATO, most personal assets are exempt from CGT, including your home, your car and most personal use assets such as furniture.
Also, Capital Gains Tax doesn’t apply to depreciated assets used solely for taxable purposes, such as business equipment or fittings in a rental property.
However, if you’re an Australian resident, CGT applies to your assets anywhere in the world.
Capital Gains Tax for foreign investors
If you are a foreign resident or a temporary resident, you:
- pay CGT only on your taxable Australian property.
- cannot claim some CGT discounts and exemptions.
Foreign residents are subject to foreign resident capital gains withholding on the sale of Australian real estate worth more than $750,000.
How your residency affects CGT:
- Foreign and temporary residents are subject to CGT only on taxable Australian property, such as real estate in Australia and assets used to carry on a business in Australia.
- The 50% CGT discount is generally not available to foreign and temporary residents for assets acquired after 8 May 2012.
- Foreign residents are not entitled to the main residence exemption unless they satisfy the requirements of the life events test.
- If you become an Australian resident or stop being one, the assets on which you pay CGT in Australia will change.
Assets you acquired before CGT started on 20 September 1985 are not subject to CGT.
How to calculate Capital Gains Tax
When you want to know how to calculate how much CGT you have to pay, other than in superannuation, there is no specific rate of tax that is applied, rather the applicable gains are added to a taxpayer’s income and the tax rate is applied to their total income, which includes the capital gain or loss.
The final tax rate will depend on your personal marginal tax rate.
CGT can be a little tricky to calculate, that's why it's so important to have specialists on your side – and especially a good taxation accountant.
Remember CGT is only payable in the financial year in which you sell or dispose of your rental property.
So, if you follow a long-term wealth creation strategy you won't need to worry about paying this for many years or possibly decades.
In the meantime, you can access any capital growth to grow your portfolio and improve your overall financial position.
For most CGT events, your capital gain is the difference between your capital proceeds and the cost base of your CGT asset – that is, where you receive more for an asset than it cost you.
According to the ATO, the cost base of a CGT asset is largely what you paid for it, together with some other costs associated with acquiring, holding and disposing of it.
If the rental property or asset was acquired before 1985, then no CGT is payable, however, major improvements to a property since that time may be subject to CGT.
You can choose the method that gives you the best result (that is, the smallest capital gain) as long as you satisfy certain conditions.
The following are three different calculations.
- CGT discount method
For assets held for 12 months or more before the relevant CGT event. Allows you to reduce your capital gain by:
- 50% for individuals (including partners in partnerships) and trusts
- 3% for complying with super funds.
This is generally not available to companies.
An example of using the CGT discount method is:
Julie buys a rental property on 1 June 2014 for $300,000 and sells it for $350,000 on 15 July 2015.
As she owned the asset for more than 12 months she is entitled to the 50% CGT discount.
She would need to also subtract the cost base from the capital proceeds, deduct any capital losses, then reduce by the relevant discount percentage.
- Indexation method
For assets acquired before 11.45 am (by legal time in the ACT) on 21 September 1999 (and held for 12 months or more before the relevant CGT event).
This method allows you to increase the cost base by applying an indexation factor based on the consumer price index (CPI) up to September 1999.
The indexation method increases the purchase costs by using an indexation to factor in the inflation between the date you purchased your asset, and the date you sold it.
The CGT index is calculated by dividing the consumer price index (CPI) at the time you sold your property, by the CPI at the time you bought the property (rounded to three decimal places).
As a formula, this will look like this:
A= is the indexation factor.
B= is CPI for the time period (quarter) when the CGT event occurred.
C= is CPI for the time period (quarter) in which expenditure was incurred.
It’s important to note, that the ATO provides a consumer price index (CPI) each quarter, which you can use to calculate your capital gain.
Here is the ATO’s example of using the CGT indexation method:
Val bought an investment property for $150,000 under a contract dated 24 June 1991. She paid:
- a deposit of $15,000 on 24 June 1991
- the balance of $135,000 on settlement on 5 August 1991
- stamp duty of $5,000 on 20 July 1991
- solicitor's fees of $2,000 on 5 August 1991 as part of settlement.
Val sold the property on 15 October 2016 (the day contracts were exchanged) for $600,000. She incurred costs of:
- $1,500 in solicitor’s fees
- $15,000 in agent’s commission.
Using the steps above, Val works out her cost base as follows.
- The costs of buying the property are eligible for indexation. They were incurred prior to 21 September 1999.
- The CPI rates for the quarters in which Val incurred her eligible costs are:
- deposit and balance: CPI for June 1991 quarter = 59.0
- stamp duty and solicitor's fees: CPI for September 1991 quarter = 59.3
- Although the balance was paid in the September quarter, it is indexed from the date of contract, which was in the June quarter.
So the indexation factors are:
- for the June 1991 quarter: 68.7 ÷ 59.0 = 1.164
- for the September 1991 quarter: 68.7 ÷ 59.3 = 1.159
This means the indexed costs are:
Deposit × indexation factor: $15,000 × 1.164 = $17,460
Balance × indexation factor: $135,000 × 1.164 = $157,140
Stamp duty × indexation factor: $5,000 × 1.159 = $5,795
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Solicitors’ fees for purchase of property × indexation factor: $2,000 × 1.159 = $2,318
So Val's total cost base is $199,213, made up of:
- indexed costs $17,460 + $157,140 + $5,795 + $2,318 = $182,713
- $1,500 solicitor’s fees for sale of property (not eligible for indexation)
- $15,000 agent’s commission for sale of property (not eligible for indexation)
Using indexation, Val's capital gain for the asset is:
Capital proceeds ($600,000) − cost base (indexed) ($199,213) = a capital gain of $400,787.
- Basic method
This method is for assets held for less than 12 months before the relevant CGT event.
To determine whether you acquired the asset at least 12 months before the CGT event, exclude both the day of acquisition and the day of the CGT event.
The basic method of subtracting the cost base from the capital proceeds.
So the calculation looks something like this: Asset Sale Price – Cost Base = Capital Proceeds.
Here’s an example of using the basic CGT method:
Georgina purchased a property for $300,000 under a contract dated 10 May 2019.
The contract provided for payment of a deposit of $25,000 on that date, with the balance of $275,000 to be paid on the settlement on 1 August 2019.
Georgina also paid stamp duty of $7,000 on 12 July 2019. On 1 August 2019, she received a bill for the solicitor’s fees of $3,000 which was paid together with the settlement.
Georgina subsequently sold the property on 30 October 2011 (the day contracts were exchanged) for $380,000.
During the disposal process, she incurred costs of $1,700 in solicitor’s fees and $3,000 in real estate agent’s commission.
Remember: There are a number of CGT calculators available online so you can work out how much CGT you might have to pay if you sell a rental property.
It's important, of course, to use a specialist taxation accountant when it comes to time to lodge your tax return for the financial year in which you've disposed of the asset.
Capital Gains Tax on an investment property
Whether you put a tenant into your home before you live there or the other way around makes a big difference as well as the 6-year rule for exemption of your home from CGT.
In summary, you can retain your main residence exemption for up to 6 years once you move out unless, of course, you’ve identified another property as your main residence.
You can only have one residence for tax exemption at a time.
The beauty of it is you don’t have to identify which residence until you sell one.
Then you do the numbers and you work out which property gives you the best tax advantage.
In this regard, the ATO is pretty good.
To calculate the tax, what we need to do is go back and determine the market value of the property at the time you moved out which then sets up the cost base to determine the profit on the sale.
You get the selling price less any costs, of course, and you compare it back to the market value on the date you moved out and rented the property.
That creates the profit that we then look at to see how much is taxable.
The way we calculate what’s taxable is we look at the number of days you’ve owned it in total and you compare that to the number of days you had a tenant in there while taking into account up to 6 years, you can have it as tax-free.
So it’s a proportion of the number of days you had a tenant versus the number of days you owned it, but you only multiply that against the profit based on the market value at the time you sold.
Capital Gains Tax on a commercial property
CGT on commercial properties works in a similar way to residential properties.
But there are 4 key differences, listed below:
- Unlike residential property where the family home is exempt from CGT, owner-occupied commercial property is not exempt from the tax. But, there are a number of discounts available for certain ownership and usage structures.
- Companies are not eligible for the 50% discount on assets held for more than 12 months.
- There are particular discounts and offsets available for certain types of commercial property owners (outlined below).
- Farms and home-based businesses are treated differently for tax purposes.
In addition to CGT, commercial property owners are also generally liable to pay the Goods and Services Tax (GST).
Capital Gains Tax on an inherited property
Generally, CGT does not apply when you inherit property but it may apply when you later dispose of or sell it.
That’s because, in the case of an inherited or deceased estate, the transfer of ownership to you (i.e the inheritance transaction) isn’t considered a CGT event.
And if the transfer isn’t considered a CGT event, there is no capital gains tax liability.
However, if you decide to sell the property, CGT on the inherited property may apply.
In fact, according to the ATO, even If you inherit a property and later sell it, you may be exempt from CGT.
The same applies if you are the trustee of a deceased estate.
Whether CGT is applicable depends on:
- When the deceased acquired the property
- How did the deceased use the property while they owned it (i.e. was it the deceased’s main residence or was it used to produce income?)
- The deceased’s date of death
- Whether the deceased was an Australian citizen at the time of their death
- Whether you were an Australian resident when you sold the inherited property.
Generally, if the deceased died before 20 September 1985 and the property transfer also occurred before that date (i.e. the property is a pre CGT asset), you’ll be completely exempt from CGT.
If the deceased purchased the property before 20 September 1985, but you inherited it after that date, the following conditions need to be met in order to be exempt from CGT:
- You sold the property within a 2 year period
- The inherited property becomes the main residence.
How to legally avoid or reduce Capital Gains Tax in Australia
If you're looking for some ways to reduce your CGT, here are some ideas...
1. Avoiding CGT by living on the property
When it comes to property, one of the major exemptions from CGT is if it's your home or principal place of residence (PPOR).
You can generally claim the main residence exemption from CGT for your home.
To get the exemption, the property must have a dwelling on it and you must have lived in it.
You're not entitled to the exemption for a vacant block.
Generally, a dwelling is considered to be your main residence if:
- You and your family live in it
- Your personal belongings are in it
- It is the address your mail is delivered to
- It is your address on the electoral roll
- Services such as phones, gas, and power are connected.
There is also a tax break that you may be able to access if your PPOR becomes a rental property.
As I mentioned before, there is a special 6-year rule, which means that a property that was previously your PPOR can continue to be exempt from CGT if sold within 6 years of first being rented out.
The exemption is only available where no other property is nominated as your main residence.
What's interesting about this rule is that if the same dwelling is reoccupied as your main residence, then the 6-year exemption resets.
So another 6 years of exemption is available from the date it next becomes income-producing.
2. Paying CGT if your main residence is used for business
Advancements in technology mean that more and more people are working either from home or working for themselves.
A tax issue that many people find themselves in, however, is that if they work from home or use the home for business purposes, that may trigger some form of CGT.
It's important to understand that if your employer has an office in the city or town where you live, your home office will not be a place of business, even if your work requires you to work outside normal business hours.
Also if your income includes personal services income, you may not be able to claim a deduction for occupancy expenses.
According to the ATO, it's important to consider any CGT impacts of claiming your home as a business premise.
To work out the capital gain that is not exempt, you need to take into account a number of factors including:
- The proportion of the floor area of your home is set aside to produce income
- The period you use it for this purpose
- Whether you're eligible for the "absence" or six-year rule
- Whether it was first used to produce income after 20 August 1996.
3. Avoiding CGT with a self-managed super fund
The ability to borrow money to invest in property, in particular, by using the mechanism of an SMSF has resulted in the number of funds increasing rapidly in recent years.
There were 598,000 SMSFs in operation, according to the latest statistics released by the ATO (for December 2021).
While people have generally always been able to buy a property through SMSFs, what has changed in the past few years is that SMSFs can now borrow money to do so.
Buying a property through an SMSF should not be the sole reason that someone chooses to set up an SMSF but it can be an option for people who want more control over their super.
Similarly, it's important to not consider buying the property with an SMSF solely as a way to avoid or minimise paying CGT.
It should work for your long-term investment strategy as well as meet a number of checks and balances for your financial future.
If you do choose to invest in property using an SMSF, the unique ownership structure provides a number of taxation benefits.
If you sell the property once you've retired, you'll pay no capital gains on the property.
There's also a 33% discount available under the CGT discount method calculation.
Borrowing or gearing your super into the property must be done under very strict borrowing conditions and can present investment risks.
Some of the property risks associated with geared real estate bought via an SMSF include:
- Higher costs – SMSF property loans can be more costly than other property loans, which must be factored into your investment decision.
- Cash flow – loan repayments must be made from your SMSF, which means your fund must always have sufficient liquidity or cash flow to meet the loan repayments.
- Hard to cancel – If your SMSF property loan documentation and contract is not set up correctly, unwinding the arrangement may not be allowed and you may be required to sell the property, potentially causing substantial losses to the SMSF.
- Possible tax losses – Any tax losses from the property cannot be offset against your taxable income outside the fund.
- No alterations to the property – Until the SMSF property loan is paid off alterations to a property cannot be made if they change the character of the property.