What is capital gains tax?
Capital gains tax (CGT) is a tax on the profit you make when you sell CGT assets, like an investment property or shares. Aside from property investors, owner occupiers may also face this tax if they used their home to run a business (for example, this could be a sole trader). You could also be subject to this tax when you trigger a CGT event, which includes the loss, theft or destruction of a property.
To assist your CGT calculations, the Australian Taxation Office (ATO) defines a capital gain as the difference between your cost base and capital proceeds.
- Simply put, the cost base is the purchase price plus costs of owning, maintaining, and selling the property.
- This could include stamp duty, legal fees, renovations, and real estate agent commissions.
- Your capital proceeds is what you receive from the sale.
Keep in mind you only pay gains tax when selling for more than you bought it for.
How do I avoid capital gains tax on an investment property?
Capital gains taxes can cut into your profits, leaving you with less money to reinvest or use for other purposes. But there are legal ways to potentially avoid paying capital gains tax on investment property. Seek professional advice from a tax accountant or financial advisor to check if you’re eligible.
The 6-year rule lets you treat an investment property that you lived in previously as your primary residence (for tax purposes) for up to 6 years, even if it was used to generate rental income. As a result, you’ll be exempt from paying CGT for those 6 years when you sell the property. You can reset the 6-year rule and maintain the exemption if you move back in before the 6 years are up. In theory, this means that you could avoid capital gains tax, as long as you’re not away from the property for more than 6 years.
You must meet certain conditions to be eligible:
- During the 6-year period, you cannot treat any other property as your primary residence.
- The property must have been your primary residence before you rented it out.
You can decide which property is your main residence when you sell, and a tax accountant can help you with it.
If you own a vacant land block and build a house on it, you typically have to pay capital gains tax on the land until you move into the house and make it your main residence. But you may be able to treat the land as your main residence for up to 4 years before you live in it, if you meet the criteria. You must:
- own the land
- build, repair or renovate a home on the land, or complete construction on one that's already started
- move into the home as soon as possible and live there for at least 3 months
- not treat any other property as your primary residence during the 4-year period.
You could also qualify if you’re demolishing an existing dwelling and building a new one.
How do I reduce capital gains tax on an investment property?
If you can’t take advantage of the above tax breaks, there are ways to help you potentially reduce capital gains tax. If you think you could be eligible, use a capital gains tax calculator to help you see how the CGT discounts may apply to you.
50% capital gains tax discount
The CGT discount allows you to reduce gains taxes on property by 50% when you sell, which in turn can help lessen your tax liabilities. To be eligible, you must:
- have owned the property for at least 12 months and
- be an Australian resident for tax purposes.
Individuals and trusts are eligible for the CGT discount, while companies aren’t.
If you acquired a property in one of these ways, you can include the time the previous owner had it when calculating if you've had it for 12 months:
- You inherited property from someone who died and they acquired it on or after 20 September 1985.
- You acquired it when you and your spouse broke up and you both had it for more than 12 months.
- You acquired it as a replacement for a property that was destroyed or compulsorily acquired, and both the old asset and the new one were owned for at least 12 months.
Using the indexation method to calculate capital gains tax
If you sell your investment property that was purchased before 21 September 1999, you may be able to use the indexation method. This method adjusts the amount you paid for the property to account for inflation that occurred while you held the property, which would lower your capital gains tax. You can choose to use either the inflation method or the 50% CGT discount method, depending on which method gives you the lower capital gain, but you can’t use both.
Investing via self-managed super funds
Investing in property through a self-managed super fund (SMSF) may give you tax benefits. When you sell, you may be eligible for a CGT discount of 33.33% if:
- you’ve held the investment property for over 12 months and
- your SMSF is a complying super fund.
If your SMSF is in accumulation phase (you’re still working and contributing to your super fund), capital gains are generally taxed at 15%. This means after the 33% discount, the effective tax rate is only 10%. If your SMSF is in the pension phase (you receive a retirement income stream from your SMSF), you don't have to pay any tax on the profit you make when you sell.
Investing in property through an SMSF can be complex and there are rules and regulations that must be followed. You may want to speak to a financial advisor or tax professional to make sure it's the right choice for you.
When did CGT start in Australia?
Capital gains tax was introduced in Australia on 20 September 1985. Before this time, there was no tax on capital gains in Australia.
Why is this important? Because properties acquired before this date are generally exempt from CGT and this is referred to as ‘pre-CGT status’. However, major improvements to a property made since 20 September 1985 may not hold pre-CGT status and be subject to CGT. The rules around taxes on investment properties have changed over time so speak to your tax accountant for more details.
Do you have to pay capital gains tax on an investment property?
If you sell your investment property for a profit, you generally have to pay CGT on the capital gain. The CGT applies to any property that isn’t your principal place of residence, including investment properties and holiday homes. However, there are some tax exemptions and tax deductions available to property investors, though eligibility criteria applies.
Capital gains tax is often mistaken as a separate tax. Despite the name, CGT forms part of the tax you pay on assessable income. You report any capital gains or capital losses in your tax returns. In general, when you sell your property, your capital gains will add to your taxable income - the higher your taxable income, the more tax you’ll likely pay.
If you’re a foreign resident for tax purposes, there are a few differences in how CGT rules might apply to you.
- The tax rates for foreign residents are different from the tax rates for Australian residents.
- For any property you sell in Australia after 30 June 2020, you may only claim the main residence exemption from CGT if you satisfy the requirements of the life events test.
- You can’t claim the 50% CGT discount for properties you bought after 8 May 2012.
- If you’re a foreign resident selling property worth $750,000, a capital gains withholding rate of 12.5% applies. Your purchaser is required to withhold this amount at settlement. Consider using a taxes calculator before you sell an asset to help you work out your tax liabilities.
How much capital gains tax will I pay if I sell my investment property?
The amount of CGT you will be required to pay on the sale of an investment property will depend on a number of factors, including:
- the purchase price of the property
- the cost of any improvements
- any other expenses associated with the sale
- when you purchased the property
- how long you’ve owned the property
- your taxable income and marginal tax rate
- your tax residency status (note that residency for tax purposes differs from the residency statuses used by the Department of Home Affairs).
Capital gains tax is only one possible cost you could incur when you sell your property. You may want to use a selling cost calculator before you sell.
How do you calculate capital gains tax on the sale of investment property?
To calculate capital gains tax, work out your net capital gain or loss by subtracting the cost base from the capital proceeds. If you have a net capital gain, this amount will be subject to CGT, which would be based on your marginal tax rate.
- Alex is a property investor who held her rental property for 5 years before deciding to sell it.
- Her cost base is $550,000.
- Her capital proceeds are $800,000.
- Alex's capital gain is $250,000 ($800,000 - $550,000).
- Given that she is an Australian resident and has held the property for more than 12 months, she is eligible for the 50% CGT discount.
- She is not eligible for the 6-year rule as she did not live in it before renting it out.
- Her taxable capital gain is $125,000 and she will pay tax on this gain at her marginal income tax rate.
If you get stuck, there are a range of calculators and tools online to help property investors calculate capital gains tax.
Plan ahead and keep track of your property’s history
While no one likes paying taxes, property investors can think ahead to work negative gearing and CGT into their long-term investment property tax planning.
If you do intend to use any tax exemptions or discounts, it’s important to maintain accurate records of your property's residence and rental history. Even after you sell your property, you must keep all related paperwork for at least 5 years.
Depending on the timing of your property sale, you may not always do your tax return immediately after you sell. If you’re expecting any CGT events, it’s a good idea to have funds set aside in a savings account to help cover the amount when the time comes to do your taxes.