If you’re an Australian property investor and you want to know how Capital Gains Tax works, you’ve come to the right place. This beginner’s guide to Capital Gains Tax for investment properties:
- introduces the basic concepts behind CGT in Australia
- explains what happens if your investment property was also your main residence for a portion of the time
- shows how depreciation fits into the equation, and
- provides a step-by-step guide to calculating CGT.
If you like managing your own finances and doing your own tax return, then (a) you’re awesome and (b) this post is definitely for you. The spreadsheet that accompanies this article helps to illustrate the concepts and does the math for you, and you can edit it with your own numbers to work out your CGT.
Capital Gains Tax as explained to a 5 year old:
If you sell an investment property for more than you bought it for (plus costs), you’ve made a capital gain (yay!) but now you’ve got to pay capital gains tax (boo). The amount of capital gain is added to your taxable income, just like your regular salary. But because the Australian Government is so generous, you get to apply a 50% discount to your capital gain before it gets added to your taxable income – as long as you’ve owned the property for more than a year. Your capital gain is basically the difference between your selling price and your purchase price (plus costs), or slightly-more-technically:
Capital Gains = Proceeds from sale – Cost Base
The “cost base” is the purchase cost, plus a whole lot of other costs you’ve paid along the way (including buying and selling costs and renovations – but not stuff you’ve already claimed as a tax deduction). Unless you love paying tax, you’ll want to maximise your cost base in order to minimise your capital gain, from which CGT is calculated.
How to calculate your capital gain
There are (potentially) a lot of costs involved when calculating capital gains, so the best way of keeping track of all the costs (and doing all the maths for you) is of course an engineer’s best friend – the spreadsheet. Here’s a free Google Sheets spreadsheet that illustrates many of the costs, calculations and other considerations involved in calculating CGT. You might want to keep it open on a separate in your browser while reading through the rest of this guide.
Some info about the spreadsheet:
- The spreadsheet is free and unlocked – feel free to copy or download it, then edit it as much as you want for your own evil purposes.
- However if you do share it because it’s awesome and you’ve never found anything like it on the internet before, please do send a pointer back to this site – thanks!
- If you’d like to use it to calculate your own CGT, just replace all the blue values with your own numbers.
- Use additional columns if you have multiple properties
- Let us know if you have any feedback by email or comments below.
- The spreadsheet is provided for “illustrative and educational” purposes only.
What if I lived in the investment property at some point?
You only have to pay CGT on an investment property, not on your own home that you live in. However if you lived in your investment property at some point, here are 3 common(-ish) scenarios that may apply to you:
- If you purchased the property to live in yourself, and then some time later you decide to rent it out, then the time you lived in the house yourself is not subject to capital gains tax. You can just pretend that the time you lived in the house yourself didn’t happen, and the “acquisition date” for capital gains calculations is when you start renting it out (in ATO speak, they refer to it as “the date you are taken to have acquired the property”).
- After renting out the house, if you decide to move in yourself at some point, then again you don’t have to pay CGT on the time you live in the house yourself. In that case, you still calculate the capital gains from acquisition date to sale date, but you only need to pay tax on a portion of that. That portion is calculated as:
- Portion of capital gains you need to pay tax on = number-of-days-property-rented / number-of-days-owned
- If you use the spreadsheet, you’ll see that it calculates all the parameters above for you based on the dates you put in. How good is technology?
- You don’t actually have to live in the house yourself – you can just claim that it was your main residence (don’t worry, this is totally legit, the ATO is cool with it). However you can only claim one property as your main residence at a time. So if you wanted to, you could move to Bali where the weather’s always nicer, or decide to rent somewhere cooler than your house, and during that time you can rent out your house for up to 6 years and still claim it as your main residence – as if you actually lived there yourself (so you only pay a portion of the capital gains tax based on the calculation given above). For other scenarios related to this 6-year-main-residence rule, check out the ATO’s webpage and examples.
There are a lot more rules and conditions, but this is only a beginner’s guide intended to give you an overview of how CGT works that is relevant for most people. For all the detailed rules, conditions and scenarios you could possibly think of (and more), check out the ATO’s website.
One last thing. If you purchase a house and rent it out immediately, then the purchase cost that you use in your cost base calculation is (generally) the amount you paid for it. However if the date you are taken to have acquired the property (I’ll just call it acquisition date) is long after you purchased it, then you can work out how much it was worth at that point with the help of a licensed valuer. The valuation you get is the amount you use to calculate your cost base, which is hopefully a lot more than the purchase price (you want to maximise the cost base to pay less tax, remember?). A valuer can look through historical data to work out the market value of your property at the time, so you really only need to get the valuation done when you’re selling and have a need to calculate CGT for your next tax return.
The capital gains calculation excludes plant and equipment
Before we get into how the cost base is calculated, you need to understand what the ATO considers to be in the “purchase cost” and the “proceeds from sale”. As explained in the Beginner’s Guide to Investment Property Depreciation, you should know that when you buy a property, you are really buying 3 things, the total value of which add up to the purchase cost:
- the land
- the building and all the stuff “permanently attached” to it (like the doors and toilet) – known as “building” or “capital works”
- the other stuff – known as “plant and equipment” (like the carpets and AC).
When it comes to the capital gains calculation, you exclude the plant and equipment entirely from the calculation. It is excluded from the purchase cost, and it’s excluded from the selling price. The ATO just reckons that you bought the plant for what it was worth, and sell it for what it’s worth, so you made no capital gain on it. When it comes to doing the calculations then, you must deduct the plant and equipment value from both the actual purchase cost, and the actual selling price. You should know how much the plant and equipment was worth at both times based on your depreciation schedule. If you have no idea what a depreciation schedule is, read the depreciation post first!
So if you paid someone $287000 for a property, and your depreciation schedule (or spreadsheet) tells you that a portion of that was the plant and equipment valued at $11526, then the amount you use in your cost base calculation is $287000 – 11526 = $275474.
Similarly if you end up selling that property years later for $450000, and your plant and equipment has now depreciated to just $230 (not a lot because most of the plant and equipment has exceeded its “effective life”), then the amount for your capital gains calculation is $450000 – $230 = $449770. This is known as the “proceeds from sale”. According to the ATO, what you actually did was sold some plant and equipment for $230 (even though the street value is likely to be a whole lot more) and some land and a building worth $449770. For CGT, they only care about the land and building portions. This is also illustrated in the CGT spreadsheet, which deducts the plant and equipment value from both the valuation-when-acquired and the selling price.
Cost base calculation
The cost base consists of 5 elements, which are described on the ATO’s website, but in normal human language, this is what it means:
|Elements||ATO’s description||What it actually means|
|First element||Money paid or property given for the CGT asset||Purchase price (excluding plant/equipment)|
|Second element||Incidental costs of acquiring the CGT asset or that relate to the CGT event||Other costs at purchase and selling|
|Third element||Costs of owning the CGT asset||Costs to own|
|Fourth element||Capital costs to increase or preserve the value of your asset or to install or move it||Costs to improve|
|Fifth element||Capital costs of preserving or defending your title or rights to your CGT asset||← if that description sounds like anything relevant to you, well, you’re on your own (i.e. not relevant for most people)|
Ok let’s break it down:
- The first element is what you paid for the property, minus the value of plant/equipment (since we’re ignoring that component completely in our cost base calc). Alternatively, it is the value of the property when it was “acquired”, again minus the value of the plant/equipment at the time.
- The second element are other costs and fees you paid at purchase (e.g. stamp duty, settlement agent fees etc) and selling (e.g. real estate agent and settlement agent fees). In the spreadsheet, the purchase costs are listed at the top, and the selling costs are listed at the bottom, but they are both 2nd element.
- The third element are costs you need to pay while owning the property, like insurance, rates and maintenance. If you’ve already claimed this stuff as tax deductions in previous years, you can’t include them here. However if they were not claimable (e.g. you didn’t rent out the property) then you can include them here.
- The fourth element costs improve the property, such as capital works renovations, but don’t include any plant and equipment you’ve added to the property. Don’t worry, that $4000 Air Conditioner you bought for your whinging tenant will still help to reduce your capital gains tax, as its remaining value at selling time will be subtracted off the sale price (and the rest of the value would have been claimed as depreciation).
- The fifth element costs aren’t relevant for most people, unless you’ve paid legal fees to defend the title of your property, or something quirky like that.
Keep in mind that if you claimed any of the above already as a tax deduction, don’t add it to your cost base – no double dipping.
Minus capital works deductions
Your capital gain is based on selling your property for more than you bought it for (plus other capital costs). But after you bought it, it actually went down in value due to the building’s depreciation. As a result, the capital gain you made is actually a bit greater by the total amount of the capital works depreciation you’ve claimed over the years.
Think of it like this: say you bought a car for $5000 and then sell it for $7000, you’ve made a capital gain of $2000 – easy. Now let’s say that you actually reduced the value of that car somehow – say, removed that expensive stereo from the car and sold it separately for $500. Now that car is really only worth $4500, but you still sold it for $7000 – your capital gain is now $2500. The same goes for investment properties, where the building/capital works has gone down in value – but just like the $500 cash you got for the stereo, you also get to claim capital works depreciation as tax deductions.
So the last part of the cost base calculation is to subtract your capital works depreciation from the total of the 5 elements. Therefore the cost base is calculated as:
Cost base = total of 5 element costs – capital works depreciation
Proceeds from sale
As discussed earlier, the proceeds from sale exclude plant/equipment, so are calculated as:
Proceeds from sale = selling price – value of plant and equipment
Capital Gains calculation
Your capital gains is calculated as:
Capital Gains = Proceeds from sale – Cost Base
Capital Gains Tax estimate
Ok we’re almost done, hang in there.
At this point, you’ve calculated your capital gains for a property that has been an investment 100% of the time from acquisition to sale. However, if you claim the property to be your main residence (as discussed above) for a portion of the time, then you can reduce your capital gain based on:
Reduced Capital Gain = Capital Gain × (number-of-days-property-rented / number-of-days-owned)
So if you claim the property to be your main residence for 25% of the time that you owned it (from acquisition to sale) then your capital gains is reduced to 75%.
At this point, if you have a capital loss carried over from a previous year, you can subtract it from your (reduced) capital gain now.
Finally, if you’ve owned the property for > 1 year, you get a further discount of 50%. You can also consider using the indexation method instead of the discount method for properties acquired before 21 Sept 1999 – so if that’s you, look it up here.
Now that you have your discounted and/or reduced capital gain, you can finally work out how much tax you need to pay on it. Your capital gain is added to your taxable income as if you earned it as normal salary. So the amount of tax is based on your marginal rate, and if you made a huge capital gain (good on ya) then you may even be bumped up to the next tax bracket.
The spreadsheet helps to calculate your reduced and/or discounted capital gain, and based on your marginal rate, it will calculate the amount of CGT for you.
How to calculate your capital loss
If you made a poor life choice, and actually lost money, then you calculate your capital loss just like your capital gain, but instead use a “reduced cost base” (which does not include any 3rd element costs). Unfortunately a capital loss doesn’t reduce your taxable income in the same way that a capital gain adds to your taxable income. However you can use that capital loss to offset a capital gain in the same year, or else carry it forward to offset a capital gain in a future year. Read more about it here.
Final note: This beginner’s guide to Capital Gains Tax for investment properties is considered general advice only with limited entertainment value. It is not financial advice and I do not sell financial products. I also don’t discuss every little detail or every possible scenario that may apply to you. If you have any comments or suggestions, please do let me know by email or in the comments below.