Understanding capital gains tax can lift your returns

Understanding the fine details of the capital gains tax (CGT) provisions can substantially improve investment returns and even help reduce the impact of any future increases in the tax rate applicable. Compared with paying personal income tax, being subject to CGT has major advantages.

With rare exceptions, it's difficult to postpone personal income tax assessments with income being taxed as it is earned or accrues. Similarly, applying CGT taxation on an accruals basis is not practical or acceptable with tax being payable only when assets are sold.

This allows taxpayers to choose when and if they pay tax giving them the freedom and ability to realise gains at a time of their choosing, for example in retirement when their incomes are low. Realising gains can also be deferred for indefinite periods because the CGT provisions don't treat the transfer of an asset by bequest as a sale.

In addition to allowing indefinite deferral of taxation on the gain, it also allows for the ultimate transfer of the asset to a taxpayer with a lower applicable tax rate. This provision is particularly useful for investors who bequeath properties to heirs who subsequently use them as a principal place of residence.

Given the tax deductibility of interest costs on investment loans, borrowing against assets with unrealised CGT liabilities to purchase new investments can help reduce both personal and CGT liabilities. Even when CGT rates are lower than normal income tax rates as they currently are, not realising capital gains thus avoiding paying any tax can be an effective strategy.

The higher the rate of CGT, the greater the incentive not to realise gains will be. Indeed, for assets with substantial capital appreciation, the CGT liability can and often does exceed the potential loss in both assets if asset prices fall.

Consider the case of an original CBA share purchased at $5.40 at the time of the float, now selling at over $80. Even with only 50 per cent of the realised gain subject to tax, over $38 a share is subject to the marginal tax rate resulting in a tax liability in the range of $10 to $20 a share. Such a large tax liability reduces the incentive to sell even if there's a risk of a substantial fall in the share price.

Increasing the future CGT rate will not alter these basic features of the CGT but will increase the benefits of continual ownership of assets subject to the current CGT provisions. As when the CGT was first introduced in 1985, any future changes will be applied only to newly acquired assets. Such a change thereby increases the benefits of continuing to own and not realise CGT liabilities on assets already owned.

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Daryl Dixon

Executive Chairman

Daryl Dixon is one of Australia’s foremost investment experts and a well known writer and consultant. He has provided trusted advice to thousands of personal clients over more than 25 years and is an acknowledged expert in the areas of tax, superannuation (including public sector superannuation), social security and investments.

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