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Capital gains tax is a tax paid on profits from assets when they are sold or exchanged. Although it is called capital gains tax, it is in fact a form of income tax and not a separate tax. The rate of tax is therefore the same as a person’s individual income tax rate.
Capital gains tax works like this: if a person buys a house and over time its value increases, tax is paid on the amount by which it increased when it is sold. If the asset is sold for less than what was originally paid for it, there is no capital gains tax to pay because no gain was made. That’s known as a capital loss.
“Let’s say you acquire a house for $100,000 that gradually accumulates in value to one million dollars,” says Mark Chapman, Director of Tax Communications at H&R Block. “The idea is that you should pay tax on the $900,000 which you’ve effectively earned without really doing anything to earn it.”
The tax is paid when a ‘CGT event’ occurs, such as selling the asset and making a profit. It also includes exchanging the asset or gifting it to someone.
Most countries have some form of capital gains tax, however the rate of tax varies across the globe. In Sweden and New Zealand, there is a slightly different scheme, whereby investors are taxed on profits as a form of business income.
In Australia, the tax is payable when a tax return is filed—not at the time the asset is sold.
“Ideally, when an asset is sold and a profit is made, the owner will set aside an estimate of the tax bill and will not go and spend it,” says Chapman. “However, sometimes people don’t realise that there’ll be a capital gains tax arising and then they go out and blow the profit and a tax bill arrives which they can’t pay.”
Understanding the future tax liability from selling an asset is an important part of maintaining a healthy financial position. An accountant should keep their clients abreast of any obligations, but it’s helpful to understand where you may or may not be liable.
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What Assets Attract Capital Gains Tax?
Not every kind of asset attracts a capital gains tax:
Property and CGT
Capital gains applies to investment properties. It does not apply to the primary residential home.
The calculation is simple. When a property is purchased, the cost is called the base cost. When the property is sold, the base cost is subtracted from the sale price. The difference in the buying and selling prices is the amount that attracts the tax.
Shares and CGT
Shares attract a capital gains tax when they are sold, or when a distribution is received from a managed fund—although this excludes a dividend.
Units and cryptocurrencies also attract capital gains tax.
What Assets Are Exempt?
Motorcycles (and cars) are exempt from CGT, as they are, generally speaking, depreciating assets.
“The rationale is that if you buy a new car and sell it down the track, you’re bound to get less than you paid for it,” says Chapman. “Therefore, [the Australian Taxation Office] don’t want to produce the tax implications of a capital loss that would arise on the sale.”
Since 1 July 2021, a granny flat arrangement is also exempt from capital gains tax. Such an arrangement involves giving someone the right to occupy a property for life.
How to Calculate the Capital Gains Tax Rate
After an asset is sold, subtract the sale price from the amount that was originally paid for it. Then subtract any associated costs with the transaction, such as stamp duty and legal fees. The amount that remains—assuming there is a profit—is the capital gain.
For example, if you paid $100 for shares that were purchased in 2020 and in 2022, you sell them for $1000, the capital gain is $900.
If you sold the shares for $50, there would be a capital loss of $50. You would then pay tax on your gain at your marginal tax rate.
Wait. What About the CGT Discount?
If the asset was owned for 12 months before it was sold, exchanged, or given away, the capital gains tax can be reduced by 50%. The person who sold the asset must also be an Australian resident for tax purposes.
In terms of calculating the amount of time the asset was owned, the CGT event is deemed to have taken place on the date of the contract, not the settlement date.
“The idea behind the exemption is to reward long-term investments,” says Chapman. “Short-term investments are not regarded as being especially helpful to the economy, whereas people acquiring an asset and keeping it over the longer term are contributing to economic stability. The theory is that tax rates should be reduced on those longer-term investments because they are desirable.”
For example, flipping properties is not regarded by the Australian Taxation Office as being particularly constructive. It’s more about chasing profits and so the discount does not apply for those properties held for less than 12 months.
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Frequently Asked Question (FAQs)
How can I avoid paying capital gains tax?
If the property being sold is your main residence, capital gains tax does not need to be paid on any profit earned. However, if the residence was used to generate income, the exemption may not apply.
Owning the asset for 12 months before selling it will reduce the capital gains tax by 50%.
How much is capital gains tax?
The rate of capital gains tax is the same rate as your individual income tax rate. If you usually pay an income tax rate of 30%, then the profit from the sale will be taxed at 30% too.
What is the capital gains tax on real estate?
Capital gains tax is paid on investment properties, regardless of whether they are residential property or commercial.
There is no capital gains tax to pay when a primary residence is sold.
If the property is classed as a business asset because it is used as part of the business, there are small business concessions and exemptions available to reduce or even eliminate the tax paid.
“Alternatively, the capital gain can be rolled over if you sell the business asset and invest in another one,” explains Chapman. “The theory is that it is not unearned income—it is working for you within your business.”
What is the six-year rule for capital gains?
If a former home is used to generate income—such as by renting it out—it can be treated as the main residence for up to six years after the owner vacates it. This is known as the ‘six-year rule’.
It gives a homeowner an extra six years to be exempt from paying capital gains tax just as they would if the house was considered their main residence. There are many reasons why a person may vacate their home prior to selling it, so this accommodates a situation that is common to many and ought not to be ‘penalised.’
How long do I have to live in a property to avoid capital gains tax?
“There isn’t any legal guidance surrounding the period of time a person lives in their residence to be exempt,” says Chapman. “The property simply needs to qualify as your main residence, and the ATO sets out a number of criteria for that.”
Do you actually live in the property? Is your mail sent there? Are your personal belongings there? Is it your address on the electoral role? Answering yes to these questions indicates it is the primary residence.
If you own two properties and spend an equal amount of time in both, choose the property that is likely to generate the biggest profit when it is sold as your primary residence.
