Your Mortgage’s In Focus series focuses on key concepts related to property transactions. It aims to break down the technical aspects of getting into the property market, providing an easy-to-understand guide for would-be homeowners and property investors.
Before the federal elections earlier this year, many Australians were troubled about the proposal of the Labor Party to increase the capital gains tax by 50%. The supposed changes, experts believed, would have hurt first-home buyers and retirees and would have painted a bleak outlook for the housing market.
The eventual victory of the Coalition Party dispelled these fears — with the changes to capital gains tax now out of the way, housing market sentiments started to shift to a more optimistic note. Recent market developments such as the back-to-back rate cuts and the loosening of serviceability rules for home loans are also making the housing market vibrant once again.
As the property market regains its strength, homeowners and investors need to reorient themselves to what capital gains tax is. Given that the housing market appears to be on the cusp of another positive trajectory, the property investment scene might soon be lively again, making it crucial to understand what property sales entail.
Defining capital gains
In essence, the amount you get from selling an asset is your capital gain. Let's say you bought a house for $450,000 and after five years, you managed to sell it for $520,000. In this case, you will get to pocket a capital gain of $70,000.
Capital gains refer to the difference between what it costs you to acquire the property, including all the fees incurred during the purchase, and how much you sold it for. In cases where the sold price of the property is less than the acquisition amount, you get a capital loss.
Imposing tax on capital gains
The Australian government started to impose tax on capital gains in 1985 in the efforts to level the playing field between taxpayers. Since then, any profits made from the sale or disposal of assets are charged with capital gains tax.
The concept of capital gains tax appears confusing at first. Many Australians still think that this is a separate tax, which is not. The capital gains you get from selling your property are added to your assessable income. Hence, this tax is actually part of your income tax. You can try calculating your income tax using this tool.
In this sense, if you make a capital loss, you will not be charged with this tax. The good thing here is that losses can be offset against capital gains. Net capital losses in a tax year may be carried forward indefinitely. However, these losses cannot be offset against your income.
To illustrate this: Let's assume that you made a capital loss of $20,000 last year. This year, you managed to record a capital gain of $25,000. When computing for your taxes this year, only $5,000 will be charged with capital gains tax.
Given this advantage, you have to ensure that you keep all the relevant paperwork that would prove your capital loss during the previous years.
On the other hand, if you have incurred a loss of $20,000 from a property sale and you earned $100,000 from employment income in the same year, you would not be able to deduct the loss you made from your taxable income.
Also read: 6 steps to a profitable property investment
Calculating capital gains tax
Before you attempt to calculate your capital gains tax, you must be aware of the 12-month ownership rule first. This rule posits that if you bought and sold your property within one year, your net capital gain will simply be added to your taxable income, resulting in you paying more income tax.
However, it gets complicated when you own the property for at least a year. In this situation, you would be entitled to a 50% discount. In simplest terms, only half of your capital gains would be taxable. You also get a discount of 33.3% discount when superannuation funds are involved.
For the sale of assets acquired prior to 21 September 1999, capital gains tax is computed using the indexation method. It takes into account Australia's inflation rate — while the purchase price increases, the gains go down, reducing your tax.
To help you compute for capital gains tax, you can use tools and calculators available online. These will help you estimate the amount of tax you need to pay more accurately. When still in doubt, do not hesitate to pick up the phone and reach out to a financial expert.
Dodging capital gains tax
When it comes to property, you will not be required to pay capital gains tax either when you make a loss or when you sell your principal place of residence (PPOR).
A property qualifies as your primary residence if it satisfies the following conditions:
- You and your family reside in it.
- Personal belongings are inside the property.
- It is in the address where your mail is delivered to
- It is in the address you use on the electoral roll.
- Services such as gas, phone, and power are connected to it.
A special rule applies when you turned your main residence into a rental property. In such cases, you will still be exempted from paying capital gains tax when you sold the property within six years of it being rented out. This is provided that you did not own another main residence during this time.
The six-year rule resets when you reoccupy the property as your main residence.
When you use your primary residence as a principal place of business, you would not be exempted fully from capital gains tax. A portion of the house that is set aside to produce income and the period you use it for business purposes would affect how much tax you have to settle when you sell the property.
Minimising the tax on capital gains
When you compute for your capital gains, do not forget to factor in the costs you incurred during the sale of the property. These costs include transfer fees, stamp duty, borrowing expenses, advertising costs, professional services, and other charges made to increase the value of the property such as renovations.
You have to make sure that you organise and keep all the relevant receipts related to the purchase and sale of your property. Any capital costs you incur would be added to your cost base, which will substantially lessen the capital gains taxable.
You can also minimise the duties by maintaining ownership of the property for 12 months. Doing so will automatically grant you with 50% discount on your capital gains tax.
Capital Gains Tax is just one of the concepts you need to understand when you enter property investing. Want to know how to time the property investment market? Or perhaps you are curious about what makes a property a good investment? Make sure to regularly check Your Mortgage’s Home Loan Guide section to be updated with the latest guides.