Tax Tip 203: The Pleasures of CGT: 5 Reasons Why CGT is better than Income Tax

It is not often that you use the words ‘pleasure’ and ‘tax’ in the same sentence, but if you had a choice of income tax or Capital Gains Tax (CGT) it would be more pleasurable to pay CGT (or perhaps it is actually less painful?).

Here’s why:

1. CGT Tax is only payable at the end so greater compounding during the life of the investment

Example

2 investments of $100,000:

A. one returning 0% income with 10% capital gains, or

B. One returning 10% income with 0% capital gains.

Same overall return but different tax consequences.


In year 1

A will be worth $110,000 but no tax payable yet,

B will be worth $100,000 with income of $10,000 so up to nearly $5,000 lost in tax.


In year 2

A will be worth $121,000

B will be worth $105,00

Each returning the same 10% again.

If this continues the gap between A and B will widen each year.


2. Can be avoided completely on at least one and possibly 2 properties

The main residence exemption means one asset can be completely tax free. Careful planning can allow for 2 properties to be totally exempt for the whole ownership period. Possibly 3 properties if you are old enough!

3. The 50% CGT discount

Once the tax is payable most taxpayers will actually get a 50% reduction in the tax payable because of the 50% CGT discount. This applies for assets held longer than 12 months. It doesn’t apply to income received more than 12 months!


4. Personal expenses can reduce it

Move into an investment property and costs incurred while living in the property can be used to reduce the eventual CGT – potentially to nil. These are the 3rd element cost base expenses and include interest, rates, repairs, insurances etc. You can’t do this with income.


5. Time to Plan

CGT can be minimised by careful planning. This can involve timing strategies, bringing forward other expenses and other strategies some of which I have outlined at:
Tax Tip 119: How to Reduce CGT on Investment Property (Part I) Tax Tip 119: How to Reduce CGT on Investment Property (Part I)

 

One of the two "problems"with CGT is people fail to understand the difference between ordinary income and capital gains. CGT is a new tax (thank you Bob Hawke) and prior to that tax law still dealt with some profits as ordinary income and that hasnt changed.

Generally speaking a profit is either a CGT gain or income. In rare instances it could be both and CGT laws may permit the taxpayer to elect which.

A CGT event can only apply to a CGT asset. Sometimes people buy a asset and think its a CGT asset. And it isnt. Examples:
- Jim buys a property to renovate and sell.
- Dave and Mary buy a property intending to develop the site and build villas and sell them
- Martha is a builder and buys land to build a duplex. She plans to live in one but plans to sell both
- Stuart trades bitcoin and shares frequently this year as he wasnt working. He has a CGT carried forward loss and plans to offset the profit this year against those losses.

The other problem with CGT is it is triggered by a "CGT event" and these are prescribed by law unlike income which is just to statutory law and common law.. Many taxpayers understand the concept of earning income but dont understand what a CGT event is as they say "but I didnt sell it". For example declaration of trust is a CGT event yet no legal ownership has changed. Or a owner of land may incur a CGT event merely by changing the way the land is used eg it becomes trading stock of an enterprise.

A 6th key issue to add to Terrys list is that some "profits" may be eligible for small business concessions if they are a eligible CGT asset. This can significantly reduce or avoid tax. Planning and advice are paramount BEFORE doing anything. Another newer concession often ignored is the superannuation downsizer concession for those over age 65.

 

the small business CGT concessions are a big one for number 6. Where else could you make a million dollars or more and not have to pay tax!

 

I recall a good example of the small business concessions which should be a lesson for anyone facing a sale of their business. They sought a second opinion.

They were a bus company. Offered a significant sum for the routes and operations. The buyer offered $X million. In the excitement they never sought advice and willingly went along with the buyer proposals. The contract was framed to sell the bus fleet as tangible assets and they paid $1 for all the non specific assets, goodwill etc. This meant :
- The sale was subject to GST and couldnt comply with the going concern basis either
; and
- The sale of buses meant all vehicles produced a huge profit (as they had largely been depreciated to $0 value). No CGT outcomes. Taxed as company profits.
- No small business concessions
- Shareholders were also subject to final taxation as the family decided to distribute the cash as a "dividend", again without advice.

 

a few thousand $$ in advice could have saved them hundreds of thousands in tax, if not more.

 

Doesnt that make mockery of the ALP proposed policy.

 

Terry, could you please expand on this as to how it's possible to potentially avoid CGT for 2 or 3 investment properties, thanks. I always thought it was only possible on one property, being the main residence only.

 

Yes got a.draft tip on this

 

Its a complex but common issue

1. The main residence exemption is a choice. Typically the first sold will be claimed BUT if that property is a loss it may be best NOT claimed and deferred to the other property`. This can also be assisted by third element cgt costs and s118-192 valuation sand more. There can also be strategies to ensure and business use IS reflected and not ignored as some may prefer.
2. Multiple properties can each be eligible subject to matters like dates and also the absence rule.
3. Spouses CANNOT each have a property each but historical exemption s can still occur
4. Pre-CGT property
5. Foreign v's domestic main residence property (The effect of FX and residency tax issues can assist a CGT choice !!)
6. 4 year construction rule v's other property

Its a area where personal tax advice can represent excellent value. We can advise of optimal strategies and choices which many taxpayers overlook.

 

I was going to approach that question from a different angle from Paul's comments above. I think it is great to put ideas up as you can hear different opinions from others (and there is more than one way to skin a cat.)

 

We often hear taxpayers who think they have a single main residence exemption. Reality is they may or may not have many options and choices. For what seems such a simple tax exemption its remarkably complex and every position is different to another.