Understanding How Capital Gain Tax Works

It is one of those property taxes that seems to involve complex formulas of multiplying by half your grandmother’s age, but capital gains tax (CGT) is not as complex as we all believe. Well, not quite.

Perhaps the perceived complexity lies in the number of changes to how it is calculated since 1985, when it came into being, and there’s no doubt there are some technicalities that can entirely change the amount you may need to pay.

What is Capital Gains Tax?

Capital gains tax is payable on the profit made on the sale of any capital item, which can include shares, units in unit trusts, cars, businesses and property.

When selling your primary place of residence (your home), the good news is you don’t have to pay CGT at all. But, if you have a holiday home, investment property or have hung on to an inherited property for more than year, there’s a good chance you will be hit with this tax.

If you rent out a property that was once your primary place of residence, you are liable for CGT for the period you were not living there, but not if you sell within six years of renting it out. The period doesn’t have to be continuous though, so if you had a vacant period it is not included in the six years count.

If you have owned an investment property, that you haven’t lived in, for a minimum of 12 months, then you become entitled to a 50 per cent discount in CGT.

How to calculate CGT and how to minimise it

Capital gains tax is payable on the profit you make between your purchase and subsequent sale of a property minus any sales transaction fees, leasing agent fees or maintenance costs incurred while it was being rented. This is referred to in financial circles as your “capital gain”.

If you have owned the property for longer than a year, then 50 per cent of the profit is exempt and the remaining 50 percent of the profit is taxed at your marginal tax rate (the amount of tax you pay on your income).

If you have owned the property for less than a year, then you need to pay tax on the full profit made. With current real estate prices and increases, it is definitely worth considering holding onto your investment property for more than 12 months if you can.

For example, if you are on a high tax rate of 45 percent, and make a $100,000 capital gain after two years of property ownership, then you can claim a 50 percent exemption, making tax payable at a rate of 45 percent on the remaining $50,000 of your capital gain ($22,500)

If you lived in your home for more than a year before you rented it out, it is worth valuing your home before you rent it out, otherwise the tax payable is calculated on your purchase price.

If you rent your property, the capital gain is calculated on the difference between the final sale price and the value from the period it was rented. If you did not get a valuation done, then it is valued on the price you purchased at.

This is where it can get quite technical. Let’s assume you bought a home in 2001 for $150,000 and lived there for five years before renting it out for a further seven. If it was valued at $500,000 at the time of renting it in 2006 and you sold it for $490,000 in 2013, then technically (for tax purposes) you have made a capital loss of $10,000 which can be offset against a current of future capital gain.

If, however, you did not get the pre-rental valuation, then you would be liable for tax on a capital gain of $340,000 profit from your original purchase price in 2001 (minus an exemption for the period you lived there).

If you inherited the property, you may be entitled to CGT exemptions. (link to the deceased estate article)

The ATO has some useful information to help you calculate you CGT and it is worth seeking the advice of a qualified financial planner to get a full understanding of CGT for your own circumstances, as this post should not be used in place of financial advice.