A capital gain is a difference between
what was paid for an asset
and what it sold for
(with an allowance for costs of purchase and sale)
Introduced in 1985, Capital Gains Tax was part of a move to broaden the base of taxation in Australia. Previously, the income derived from the profitable sale of shares or a property investment was tax-free.
The situation was inequitable as some people were able to make an income and pay no tax at all.
Broadening the base of taxation involves collecting tax from a more extensive range of sources in the hope of raising more tax revenue (on previously exempt sources of income) and from more people.
The rationale behind the reform was that it was fair and equitable to make everyone pay a share of the tax revenue needed to support the government’s activities, including the public goods that all Australian’s benefit from regardless of their employment or income source. It also would make possible a reduction in the burden on PAYG income taxpayers, who constitute the majority of taxpayers.
CGT is not a separate tax – it is part of the income tax regime and is treated as such.
If you buy and sell an asset within 12 months, of 100% the gain (adjusted for inflation and costs) is added to your assessable income and tax is levied at your top your marginal rate.
However, as an individual, (company structures receive no discount and pay 30% CGT) if you have owned the asset for more than 12 months and then sell it and make a capital gain, you are entitled to a 50% discount on the amount on which the tax will be levied.
As part of the income tax system, the timing of any sale of assets is best done on the advice of your accountant. Choosing to sell an asset in a financial year in which your income is lower may assist in minimizing your CGT obligation.
Should you make a capital loss on the sale of an asset, the loss can’t be offset against your regular income but can be carried forward indefinitely to be used to reduce any future capital gain.
With property or other assets purchased in an SMSF, the tax rate is 15%, and the CGT discount is 33.3% (rather than 50% for individuals), but if you sell the property once you’ve retired (after 60), you will not be obliged to pay CGT at all.
Personal assets such as the family home, car, furniture etc. are exempt from capital gains tax.
The tax is an imposition on alternative forms of producing an income.
Remember that time in the market is most important when it relates to property investment. Given the significant entry and exit costs associated with a property, coming in and out of the market is a misguided and costly approach to what should be a long term strategy.
CGT is deferred until the sale of the property, and so property investors should never plan to pay tax on more than 50% of the capital gain. Timing becomes relevant when choosing when to sell – once again expert, and professional advice is imperative to take advantage of techniques to minimize your tax obligations legally.
Any tax will impose economic costs by influencing the decisions people and businesses make about how they work, save, invest and employ.
CGT is no exception. It may influence decisions to invest, which in turn may have broader implications for the economy, employment and growth. (remember the multiplier effect of housing construction!)
The government needs to tread a thin line between raising ample revenue, distributing the responsibility equitably across the community and the disincentive effects of tax liability. Any disincentive to invest or employ or spend will negatively affect tax revenues – think of payroll tax, income tax, GST, increased welfare payments etc.
In 1950 Australia’s tax law consisted of 1080 pages, today it exceeds 14000 pages!
Complex tax laws impose high compliance costs – time and money the community spends dealing with tax matters. The measure of a good tax is that it is simple, able to be complied with, fair and is as low as possible to avoid disincentives.
The Australian Treasury is encouraging community discussion about the need for ongoing reform and adaptation of the tax system to meet the challenges of a changing Australia.
Ownership may be divided
The decision about who will own the property and in what proportion is typically based around individual incomes and marginal tax rates, to maximise rebates and to minimise tax obligations.
However, it’s also essential to consider the future. One party to the contract may be the lower-income earner now, but their future earning potential may be very different. Depending on the time horizon of the investment; they may need to sacrifice some rebates now to benefit from more significant returns in the future.
Exit strategies should also be considered. Capital Gains Tax obligations can be minimised by timing the exit in line with periods of lower-earning, planned absences from the workforce or retirement dates, and all may influence the ownership split nominated now.
Ownership splits of 99/1 to secure the vast majority of claims in the highest income earners name are now frowned upon by ASIC. They mandate that a borrower must stand to gain a ‘distinct benefit’ from being a co-borrower and 1% no longer amounts to that in their view.
To have a 1% interest and liability still means that borrower is jointly responsible for the entire debt and they must seek independent legal counsel before committing to such an arrangement. The accountancy fees for a 1% benefit is also unlikely to be justified by the small tax benefit.
The minimum is now a preferred 80/20 split.
In the case where a couple decides to have the property 100% in the higher income earners name, if the equity offered to secure the purchase is jointly owned, the other partner will be required to be a guarantor, and therefore is jointly responsible for the loan.
What one owns, the other does too, and what one owes, the other does also!
Deciding on the ownership split is a decision best made in conjunction with your accountant and mortgage broker.
A couple buying together will nominate whether they want to be:
- Joint tenants
Joint tenants hold the property equally between them and the income or loss from the property will also be split evenly. The property can only be disposed of wholly, not in parts and on death, ownership of the property passes to the surviving owner. Most committed couples would elect to have this setup.
2. Tenants in common
Shares in the property can be uneven (in line with the lending and regulator’s guidelines), and so the income and tax benefits are attributed according to percentage ownership. Tenants in Common can dispose of their share if they choose to. On death, the will of the deceased determines the outcome of the deceased’s share in the property.
ATO – Co-owners of a rental property
Profit is the return to risk
but ‘bricks & mortar’
is relatively predictable,
safe and reliable
“Australian residential property outperformed all asset classes for the 10 and 20 years to 31 December 2017”
Source: ASX/Russell Investments
1. Inflation favours tangible assets – inflation is a sustained general increase in the prices of goods and services over time. Unlike real assets such as property, the value of bank deposits can diminish over time due to inflation. Not only do the dollars in the bank potentially buy less than when you put them in, but the interest earned may not compensate for the higher prices over time.
The ‘real interest rate’ = interest minus inflation.
Think of something you bought from your childhood, perhaps at the school canteen, what did it cost? What would it cost now?
(I provided my classes with much amusement when I’d tell them what their favourite canteen items cost in ‘my day’)
An example of the ‘time value of money’ effect is demonstrated when lottery winners are persuaded to accept regular monthly payments’ for life’ (read 20 years) rather than a lump sum now, which is customarily a bit smaller.
For example, what would you rather have? $25K per month for 20 years which equals $4.8M or $4.25M now???
Take the money NOW! The $25,000 will buy you less in 10 or 20 years than it does now.
2. Low volatility over time – records have been kept in Australia since the 1890s. During that time, the overall trend for house prices has been positive, despite variations around the trend.
Aussie 25 Years of housing trends
3. Real estate ranks between fixed income and equities on the risk-return scale – housing doesn’t provide the lowest risk, but it also doesn’t carry the highest.
4. The ‘power of leverage’– Being able to borrow a large proportion of the funds required to invest means that lenders are comfortable with the property as an investment, and you use other people’s money!
A property makes your money work harder.
$30,000 invested in the bank at 5% pa = $1500 capital gain (which is then added to your gross income and taxed)
$30,000 deposit on a $300,000 house at 5% pa = $15,000 capital gain (and costs of ownership reduce your taxable income and CGT can be deferred until exit and at a more tax suitable time)
5. Government Legislation that allows limited recourse borrowing within a Self Managed Super Fund for a property is an endorsement of the strategy as a defence against the unexpected and sudden erosion of retirement funds.
6. Favourable tax treatment. Back in the first Lesson, ‘market failure’ was introduced as an essential concept to understand. In a free-market economy such as Australia, goods and services are produced according to demand and the ability of supply to respond to that demand, in other words, via market forces. While the market is generally efficient, it is not always equitable.
Government modifies the free market by compensating for its ‘failures’ (remember the business cycle)
It provides some goods and services that the market can’t or won’t and restricts the supply of some that it would if it could, such as illicit drugs.
Rather than ‘crowd out’ (entering the market and increasing competition for funds and resources that the private sector may be competing for) more productive private sector activity, the government provides tax incentives for individuals to invest, thereby encouraging the supply of housing.
New builds, in particular, are promoted because of the multiplier effect on the economy and employment specifically. Building new properties has a ripple effect on consumption that is hard to replicate.
The public sector is typically not as efficient as the private sector. Resources are wasted by big bureaucracy that has social welfare as its agenda rather than self-interest. Consequently, there are some goods and services that the government outsources to the private sector to provide. It also offers incentives to others to do what they cannot do in sufficient numbers or with optimal efficiency – a prime example is housing!
7. Tax breaks in the form of Negative Gearing and Capital Gains Tax Discounts are strong incentives for investors to enter the housing market. Negative Gearing allows investors to claim all the costs of property ownership against their taxable income and provided the property is held for at least 12 months, the CGT payable is discounted by 50%. (dependent on the legal structure)
Depending on rent yields, prevailing interest rates, personal tax brackets and government concessions, it is possible for a property investor to own a property predominately paid for by the tenant and the tax office:
Conditions like these promote entrepreneurial spirit, the building block of the market system, and are an incentive for individuals to create wealth for their retirement, thereby reducing the burden on future generations of taxpayers.
(Remember the ideas about building a business for the future)
8. Tax on any capital gain is deferred until the asset is sold. This is when ‘timing’ becomes more relevant.
9. Rental income is reliable, it isn’t subject to individual’ management performance’, the returns are contracted in a tenancy agreement and are protected by Landlord Insurance, AND they are
NOT a DIRECT TARGET OF MONETARY POLICY
As we approach retirement, we are encouraged to take less risk, and cash is typically favoured as the least risky asset class of all, but is it really?
Given the RBA’s recent lowering of the official cash rate to a historic low of 0.25%, the returns on fixed-term deposits have fallen to levels that make it impossible to survive on. Self-funded retirees depending on interest on safe, secure bank deposits often disproportionately bear the impact of Monetary Policy adjustments to the cash rate.
Could you survive on current returns to cash?
The relatively inelastic demand for housing and the rapidly
growing population coupled with the sensitivity
of cash to lower returns due to macroeconomic management
is a powerful recommendation
for having rental income in any investor’s asset mix.
10. Interest rate rises usually mean fewer people buy their own homes and therefore demand for rental properties rises. All things being equal this should translate into higher rents.
Monetary Policy is the Reserve Bank action designed to influence both the availability and cost of finance in the economy. Interest rates are pushed up to slow the economy and curb inflation, and they are eased to boost spending and activity and therefore, employment. So, as economic circumstances change so will the prevailing cost of credit.
The upside of a rate increase is that your tax deductions increase and more people may delay buying their own home and continue to rent and put upward pressure on rents. Remember, ‘profit is the return to risk’ so you do have to take some risks if you are to build wealth for the future but make it a calculated risk.
In really low-interest-rate environments, retirees with assets dependent on bank earnings are adversely affected. When interest rates (and particularly real interest rates, taking inflation into account) are almost negligible, as they are currently, earning your retirement income from rent, even in part, is a very appealing and sensible alternative.
It is relevant here to examine the role of exogenous factors currently influencing the global and Australian economies.
Globalization means there is no escaping the effects of the COVID19 epidemic, both physically and economically.
The following excerpt from the RBA’s media release illustrates the role of government in managing the economy to moderate the effects of an exogenous ‘shock’ such as a health pandemic.
The RBA has reduced the official cash rate to a record low in the hope of stimulating consumer spending and investment borrowing. (C, I) and the government is prepared to provide stimulus through fiscal policy (G) to maintain employment. It is classic macroeconomic management.
Monetary Policy Decision Number2020-28 Date3 November 2020
Media Release Statement by Philip Lowe, Governor:
At its meeting today, the Board decided on a package of further measures to support job creation and the recovery of the Australian economy from the pandemic.
With Australia facing a period of high unemployment, the Reserve Bank is committed to doing what it can to support the creation of jobs. Encouragingly, the recent economic data have been a bit better than expected and the near-term outlook is better than it was three months ago. Even so, the recovery is still expected to be bumpy and drawn out and the outlook remains dependent on successful containment of the virus.
The elements of today’s package are as follows: a reduction in the cash rate target to 0.1 per cent a reduction in the target for the yield on the 3-year Australian Government bond to around 0.1 per cent a reduction in the interest rate on new drawings under the Term Funding Facility to 0.1 per cent a reduction in the interest rate on Exchange Settlement balances to zero the purchase of $100 billion of government bonds of maturities of around 5 to 10 years over the next six months.
Under the program to purchase longer-dated bonds, the Bank will buy bonds issued by the Australian Government and by the states and territories, with an expected 80/20 split. These bonds will be bought in the secondary market through regular auctions, with the first auction to be held this Thursday for Australian Government securities. Further details of the auctions are provided in the accompanying market notice.
The Bank remains prepared to purchase bonds in whatever quantity is required to achieve the 3-year yield target. Any bonds purchased to support this target would be in addition to the $100 billion bond purchase program.
At today’s meeting, the Board also considered an updated set of economic forecasts. The global economy has been recovering from the initial virus outbreaks, with the recovery most advanced in China. Even so, output in most countries remains well short of pre-pandemic levels and recent virus outbreaks pose a downside risk to the outlook, particularly in Europe. In Australia, the economic recovery is under way and positive GDP growth is now expected in the September quarter, despite the restrictions in Victoria.
It will, however, take some time to reach the pre-pandemic level of output. In the central scenario, GDP growth is expected to be around 6 per cent over the year to June 2021 and 4 per cent in 2022. The unemployment rate is expected to remain high, but to peak at a little below 8 per cent, rather than the 10 per cent expected previously. At the end of 2022, the unemployment rate is forecast to be around 6 per cent. This extended period of high unemployment and excess capacity is expected to result in subdued increases in wages and prices over coming years.
In underlying terms, inflation is forecast to be 1 per cent in 2021 and 1½ per cent in 2022. In the most recent quarter, year-ended CPI inflation was 0.7 per cent and, in underlying terms, inflation was 1¼ per cent. The Board views addressing the high rate of unemployment as an important national priority. Today’s policy package, together with the earlier measures by the RBA, will help in this effort.
The RBA’s response is complementary to the significant steps taken by the Australian Government, including in the recent budget, to support jobs and economic growth.
The combination of the RBA’s bond purchases and lower interest rates across the yield curve will assist the recovery by: lowering financing costs for borrowers; contributing to a lower exchange rate than otherwise; and supporting asset prices and balance sheets. At the same time, the RBA’s Term Funding Facility is contributing to low funding costs and supporting the supply of credit to the economy. To date, authorised deposit-taking institutions have drawn $83 billion under this facility and have access to a further $104 billion.
Given the outlook for both employment and inflation, monetary and fiscal support will be required for some time. For its part, the Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market.
Given the outlook, the Board is not expecting to increase the cash rate for at least three years. The Board will keep the size of the bond purchase program under review, particularly in light of the evolving outlook for jobs and inflation. The Board is prepared to do more if necessary.
11. Investment in property is socially beneficial. Private sector activity is supported through negative gearing and results in a more efficient allocation of resources and the creation of jobs.
12. Risks can be mitigated through insurances
There are always trade-offs, and with property as an investment vehicle they are:
- It’s a long term strategy – property investment is not a strategy that you should come in and out of on a short term basis. That approach amounts to speculation and relies on investors being able to second guess what is going to happen or implementing a ‘crystal ball’ approach which is very risky. Property investment requires a long term commitment.
- It is a relatively illiquid asset. Liquidity refers to the ease at which an asset can be transferred into cash at will. (But this also helps to reduce volatility)
- It is an asset that you cannot divest from in part! Property is largely an indivisible asset. You can’t sell half a house (assuming it’s not a strata-titled duplex in which case you might be able to or as you will see later in the course, you have individual shares in a property).
- Costs such as land tax (a state-based tax levied on land ownership that applies beyond a threshold value which is different in each state) is another reason to diversify.
- Capital gains tax is levied on any profits on exit. (can be minimized through expert advice and timing your exit in a lower marginal tax rate period).
- Management of a real estate asset also requires ongoing involvement to a greater degree by the investor than it would in other cases.