Posted by andyfvp on Jul 6th, 2008

This edited article has been provided to Finance ViewPoint by Raj Kuckreja CA, of Kuckreja Accounting and Taxation Services Pty Ltd (Phone: 02-9708-6978). The information in this article is general in nature and DOES not represent individual financial or taxation advice. Liability limited by a scheme approved under the Professional Standards Legislation

Capital gains are the profits that an investor realizes when he or she sells a capital asset (eg a Stock holding) for a price that is higher than the purchase price plus transaction costs. Capital gains taxes are only triggered when an asset is sold, not while it is held by the investor. Hence smart investing should factor in the capital gains tax implications to legally minimize the taxes you pay and maximise your take home profits. Some major assets like the family home (the primary residence), are exempt from capital gains. The focus of this article though is on capital gains tax in relation to equities.

Capital Gains Tax is NOT a stand-alone tax with a fixed rate. Any taxable capital gain made in a financial year is added to your taxable income. Tax is paid at your marginal tax rates; hence capital gains tax rate varies depending on your other taxable income. Because it is variable and dependent on other income, effective forward planning can minimise your end of your tax liability.

At this time of the year you should be reviewing your investments and determining the following:
1. How much capital gains /capital losses have already been recognised during the year
2. Are there any assets with capital losses or gains that you will be better of recognising this financial year rather than future financial year?

Keep in mind the Contract dates (NOT Settlement dates) are the important dates for determining which financial year a gain is taxed and if an asset has been held for more than twelve months. Here is a walk through on how capital gains and associated taxes are figured:

CGT Example

Assume you purchased BHP Shares in September 2004 for $10,000 and sold them in May 08 for $60,000*. As you have held the shares for at least 12 months and one day – only half of the gain will be taxable under Australian tax law. i.e. (60,000 – 10,000) x 50% = $25,000. The actual tax you pay on the $25,000 will be depended on an individual’s marginal tax rate. If you are earning over $150,000 (in 2008 financial year), that will mean 46.5% of half the gain. $25,000 x 46.5% = $11,625.00

*Note : Transaction costs for buying and selling the shares can be added to your cost base as well and will reduce your tax liability, so make sure you keep a track of these.

Assume you also owned Zinifex (ZFX) shares and purchased them in 2006 for $60,000 and today they are worth $40,000. Before financial year you can consider selling these shares. This will recognise a capital loss of $20,000. The sale contract must be before 30 June for the capital loss to be recognised.

A CAPITAL LOSS is not a tax deduction. It can only be used to reduce your capital gains. The $20,000 capital loss will reduce the gain on BHP shares. It is important to understand the net capital gain will be:

$50000 (Gain on BHP Shares) - $20,000 (Loss on Zinifex) = $30,000 x 50% = $15,000

That is the loss reduces the total gain FIRST and the CGT long term holding discount (50%) comes second.

However by recognising the capital loss before financial year you have effectively reduced your taxable income by $10,000. This reduces the tax payable by $4,650 if you are in the top marginal tax rate.

Selling for Tax Purposes and the Wash Rule

Often the question then comes up you want to reduce your tax bill and sell Zinifex shares, but you still think it is a good investment. Can you sell the shares and repurchase, for the sole reason to recognise the capital loss? In the past this was common practice. However the ATO seems to be clamping down on this practice in recent times. They have been actively issuing rulings and alerts warning people that if there is a “Wash Sale” - A scheme of buying and selling shares with the sole purpose to obtain a tax benefit - they will ignore the tax effect of such transactions and charge penalties.

The net result is you need to sell down Zinifex and either (a) not re-purchase OR (b) make the reason for selling and buying back is not about tax. For example you need to obtain and document advice justifying reason for selling Zinifex because it is not longer a good investment, and if you want to re-purchase shares in the future obtain and document advice as to why you have changed your mind. By documenting your financial advice for buying / selling and not holding the shares for an appropriate time – the sole reason for the sale and re-purchase may no longer be taxation – rather financial.

In summary

Capital gains tax planning is only one part of the puzzle and must fit in with overall tax and superannuation planning, but remember to always seek advice when it comes to taxation. More often than not the advice will more than pay for itself.

This is a very high level overview and I did not look into many issues such as methods of utilising capital losses, capital gains for collectables, small businesses capital gains, capital assets purchased before 1999 and adjustments for gains on properties. Leave a comment if you would like me to look into these or any other related tax topics.

Related tax articles and links:

1. Ten useful tax deductions
2. Investment Property and taxes
3. Ten Tips for Using Your Tax Refund
4. 2007/8 Tax Brackets
5. Should you hire an accountant
6. Australian Taxation office website.

Editor’s note:

Andy is an expat Aussie living in America and also the author of a popular finance blog called Finance Viewpoint. His blog looks at topics such as investing and personal finance from a local and global perspective. OurFinanceBlogs warmly welcomes Andy onboard and looks foward to many more future contributions.