Buying and selling an investment property does not only involve annual rental income or loss.
You also have to keep in mind the tax you have to pay when you sell it, known as Capital Gains Tax (CGT).
In the year of sale, you need to declare this capital gain or loss in your tax return.
How is your capital gain calculated?
A capital gain is calculated by taking the capital proceeds you receive less the cost base of your property.The proceeds include the amount of money the property was sold for.
So, the capital gain is calculated as follows:
Capital gain or loss = capital proceeds less cost base of your property
Where, the capital proceeds is the sale price as per the contract of sale.
And the cost base is generally the purchase price of the property when you bought it, plus costs associated with purchasing, holding and selling said property. It can include stamp duty paid, surveyor, conveyancer’s fees, loan application and mortgage discharge fees etc. less building depreciation claimed along the way.
How do I calculate capital gains tax on rental property?
Here’s how a capital gains tax is calculated on a rental property.
So, if an investor sold their property for the list price of $400,000, their proceeds are $400,000. If they bought the property for $200,000, and paid $2,000 of legal fees to buy, $20,000 of stamp duty to buy, $2,000 of legal fees to sell, $10,000 agents commission to sell and claimed $50,000 of building depreciation, their cost base is $184,000.
Their gross capital gain is the proceeds less the cost base being $216,000. If they owned the property for more than one year the net taxable capital can be halved, so they only declare $108,000 in their tax return as capital gains.
This amount is added to their regular income and tax is paid accordingly just like a regular taxable income.
What is a capital loss?
A capital loss is calculated very similar to a capital gain. While a capital gain is added to your regular income to calculate your tax, a capital loss cannot be used to offset your regular income.
It is carried forward to be offset against future capital gains only, so you do not get an immediate tax benefit from a capital loss unless you have capital gains. This is the downside of a capital loss.
Capital gains for trusts & companies
Also, if the property you owned was purchased before the 1990’s, or was not residential, your cost base is slightly changed.
Speak to an accountant
This information is general only and has been provided by Lucentor Pty Ltd who are accountants that specialise in tax for property investors.
We recommend investors obtain financial advice specific to their situation before making any investment or decision regarding their finances.
Tips on capital gains tax
What’s the best, typical, worst-case scenario with CGT when investors sell their rental property?
The best situation is they pay no capital gains tax. This is the case if they have lived in it previously as their home, and later can use some of the 6-year rule.
A typical case is investors will pay capital gains tax but at least pay tax only on half of the gain due to owning the property for over 1 year.
Worse case situation is an investor buys the property, then sells it within a year. And at the same time do major renovations to make it a new property as per ATO. Here they will pay full income tax on the gain and also be subject to GST on the sale price.
What are some common misconceptions around CGT?
- Some people think your cost base is indexed with inflation over time so a small gain is not taxable. This is not true.
- Some people think that you can transfer property between family members or to related businesses and pay no CGT. This is not correct.
- Some people think an inherited investment property is always at a market value cost. Sorry, sometimes you inherit your relative’s low-cost base and CGT liability as well.
What can investors do to minimise the CGT payable?
The best thing to remember is to sell with the capital gains discount guaranteed (e.g. hold the property for more than 12 months).
Also if you have multiple owners (eg husband and wife) the overall tax rate can be lower due to our stepped income tax rates.
Where do investors go wrong with capital works deductions or depreciation claimed when calculating CGT?
Some investors estimate the capital works deduction themselves, which should only be done by a quantity surveyor.
Also, some properties no longer have plant and equipment depreciation, even for newer second-hand apartments. This is a consideration that can affect after-tax cash flow.
What’s something that often catches investors off-guard when talking about CGT?
The most common one is mistaking a development profit with a capital gain. The ATO is very clear that property development is fully taxable with no CGT concessions.
Are granny flats exempt from CGT?
The family home is generally exempt from capital gains tax (CGT), but your granny flat may not be.
Whether your property is exempt or not depends on how you use the flat. Generally speaking, if you’re renting the flat out to a third party, this would be considered commercial rent, meaning your property could become partially liable to CGT in the event of a sale.
Interestingly, following the 2020 budget announcement, the federal government plans to scrap capital gains tax for granny flats, where there is a written formal agreement with relatives who are older or are living with a disability.
What are the different methods of calculating CGT on an investment property?
There are three methods of calculating the capital gains tax on an investment property:
- CGT Discount Method
- Other Method
- Indexation Method
CGT Discount Method
The CGT Discount Method allows you to discount your capital gain by 50% if you’ve owned the property for at least 12 months.
For example, if an investor buys a property for $200,000 and holds it for 15 months, and then sells it for $400,000. He’s making a profit of $200,000.
If he selects this method, his capital gain of $200,000 is discounted by 50%. So, he will only need to declare a capital gain of $100,000.
This $100,000 is then added to the investors’ taxable income to calculate the CGT payable using this method.
Remember, the discount percentage that applies is 50% for individuals and trusts, and 33.3% for complying superfunds and eligible life insurance companies.
The other method of calculating CGT applies for properties which have been held for less than 12 months.
It is a straightforward method of subtracting the cost base from the capital proceeds, in which the full capital gain or loss is used when calculating the CGT.
The indexation method allows property investors to increase the cost base by indexing to inflation (applying the consumer price index – CPI) only if:
- You’ve acquired the property before 21 September 1999, and
- You’ve owned the asset for 12 months or more.
You can only adjust the cost base for inflation.
To calculate your capital gains using the indexation method, you can use this formula:
A ÷ B = C
A is the CPI (Consumer Price Index) for the quarter when CGT event happened
B is the CPI for the quarter in which expenditure was incurred
C is the indexation factor
For the latest CPI index, please refer to ATO’s website.
Example of using indexation method of calculating CGT
Jim bought an investment property in January 1990 for $200,000.
He pays stamp duty of $10,000 and incurs $2,000 in solicitor fees.
He sells the property in December 2019 for $400,000. He also incurred $2,000 in solicitor fees and $12,000 in selling fees (real estate agent fees, marketing costs etc.)
To calculate the capital gains using the indexation method for the January-March 1990 quarter, using the formula: 116.2/56.2 = 2.068
- Renovation $20,000
- Stamp $10,000
- Solicitor fees $5,000 All incurred in the same quarter.
35000*2.068 = $72,380 (Cost base)
Purchase price plus cost base = $272,380 (200,000+72,380)
Jim’s estimated capital gains using the indexation method is $127,620.
Jim’s estimated capital gains using the CGT discount method is 200,000 less $35000 = $165,000 x 50% = $82,500.
In this example, using the CGT discount method gives a lower capital gain.
We strongly recommend speaking with an accountant as the laws governing CGT are complex. Please seek professional advice before making any decision around tax.
How to choose between the indexation or discount methods of calculating CGT?
For assets you acquired before 21 September 1999 and have held for 12 months or more, you can choose to use the indexation method or discount method to calculate your capital gain.
The best option for you depends on a range of factors: the type of asset you own, the dates you owned it, past rates of inflation and whether you have any capital losses available.
The best option is to use both methods of calculating CGT and work out which one gives you a better result.
What is the 12 month ownership rule for CGT?
When calculating the CGT for an investment property, if you maintain ownership of the property for more than 12 months before selling it, you’re entitled to a 50% discount on the capital gains.
This means that only half of your capital gains is taxable, i.e. if you sold a rental property for $200,000 that you bought for $100,000. Your capital gain will be $100,000 which if you’ve held for more than 12 months, it is halved. So, only $50,000 is added to your taxable income for calculation of CGT.
What is the six year rule for capital gains tax?
The six year rule for capital gains tax purposes means that your main residence continues to be exempt from CGT for:
- Up to six years if it used to produce income, i.e. rented out;
- Indefinitely if it is not used to produce income.
Under the six year rule, a property can remain to be exempt from CGT if sold within six years of first being rented out. Remember, you can’t treat any other property as your main residence except for a limited time when moving houses.
The great thing about this rule is that, when the property is reoccupied as the main residence, the six-year rule resets. Basically, you can get another six years of exemption if you move into the property.
For example, if you have a home that you purchased to live in and you:
- Lived in that property as your main residence for a year.
- Then rented it out for 3 years.
- You moved back into the property for a year.
- And then rented it out for 4 years.
How does the six year CGT rule apply here?
As in the example above, when you move back into the property after renting it out for 3 years, the six year rule resets and you get another six year from the date the property becomes income producing again.
So, if you were to sell the property now, then any capital gains on sale will be exempt from CGT as this is less than six years.
No main residence exemption for expats and foreign residents for tax purposes
A new bill that passed parliament on 12 December 2019 is removing the main residence exemption for foreign residents for tax purposes and this includes Australian expats.
The bill is estimated to affect more than 100,000 Australians who are currently working and living overseas.
Even the six-year absence rule is affected by the new bill. For more information on the changes please see this page.
As always rules around CGT are complex and may change, we strongly recommend speaking to an accountant before making any decisions around taxation.