What is Capital Gains Tax? A Simple Guide for Property Investors
Ever wondered why wealthy property investors rarely sell and yet somehow seem to keep being able to find money to buy more? One of the reasons is related to how they deal with Capital Gains Tax.
But what is Capital Gains Tax (CGT) and what does it have to do with growing a property portfolio?
CGT is the tax you pay on the profit when you sell an asset (such as an investment property) that has increased in value since you purchased it. However (and this is what wealthy investors understand), you only pay CGT when you sell.
As long as you hold onto the property and never sell, you never realise the capital gain and therefore aren’t liable for CGT.
This is why many successful investors buy and hold for the long term, rather than selling. As the property rises in value over what they paid, they go back to lenders and those lenders are usually happy to loan more money against the increase in value of the property. This allows them to buy more assets without triggering a CGT event.
When is Capital Gains Tax Triggered?
CGT only occurs once you sell an asset for more than you paid for it.
If you purchase an asset for $1, then later sell it for $2, your capital gain is $1. That’s the profit you made on the sale of the asset. The ATO sees this the same way it sees income and comes knocking for their slice of the pie.
However with investment property, it doesn’t matter how much the property’s value rises while you own it. You haven’t sold it, so you haven’t realised the profit. So the ATO has to keep their distance.
Until you decide to sell your property asset, there’s no tax to pay.
Here’s an example answering the question “what is capital gains tax?”:
Imagine you purchased an investment property for $600,000 and it’s now worth $900,000. That’s $300,000 in potential profit (or capital gain). But if you haven’t sold the property, that profit is unrealised. No sale means no taxman knocking at your door.
This is why many investors take a long-term approach. Smart investors know that by holding their property, they can still benefit from capital growth without being taxed every time values rise.
What About Your Family Home?
Your family home or principal place of residence (PPR) is generally exempt from capital gains tax in Australia. This means that if you sell the home you live in, you typically won’t pay CGT on the profit you make. Of course, it’s a little more technical than this and can become really confusing when dealing with estate matters. The bottom line is that you should never assume anything to do with CGT. You should always ensure you get expert advice along the way.
This exemption is one of the reasons why many Australians focus on paying off and improving their family home first.
However, once your home builds up significant equity, did you know you could be using home equity to invest in property?
Better still, even if you do this, you can still enjoy the CGT exemption on your main residence. If you know what capital gains tax is and when it is applied (or not applied), you join the savvy investors that have a clear understanding of their path to wealth.
Key points to remember:
- If you convert your home into an investment property later, CGT rules may apply to the time the property was used to generate income, typically while it was rented out.
- You can generally choose to treat one property as your primary residence for CGT purposes (there are exceptions and rules if you own multiple properties)
As a side note, growing your wealth isn’t just dependent on building equity in your PPR. Many successful investors use the rentvesting strategy to grow their portfolio and it’s something we suggest everyone at least understands if they are looking to grow a portfolio.
How is Capital Gains Tax Calculated in Australia?
When you sell an investment property, your capital gain is calculated as:
Sale price MINUS purchase price MINUS costs = capital gain.
If you’ve owned the property for more than 12 months, you typically receive a 50% CGT discount, meaning only half of your capital gain is taxable. However note that overseas investors are not given this same discount.
For example:
| Amount | |
|---|---|
| Sale price | $900,000 |
| Purchase price | $600,000 |
| Purchase costs (stamp duty, legal fees, etc.) | $20,000 |
| Capital gain | $280,000 |
| CGT discount (50%) | $140,000 |
| Taxable capital gain | $140,000 |
That capital gain of $140,000 is then added to the owners income (or divided and added if there are multiple owners) for that financial year and taxed at their marginal tax rate.
Of course there are many ways to reduce this taxable amount and that’s where a good accountant steps in. You should never try dealing with complex issues like capital gains tax for yourself. It can end up being very expensive.
Why Holding Property Long-Term Can Be Smarter
The longer you own a property, the more likely it is to grow in value.
Can you remember what your grandparents paid for their house? I’m going to guess that it is worth considerably more today, no matter where it is located.
By holding onto your assets instead of selling, you avoid triggering a CGT event and allow compounding growth to work in your favour.
So this is where you need to ask yourself, “do you think property will be cheaper in 10 years, 20 years or even 40 years, than it is today?”
Do you wish your parents or grandparents would have purchased more property in the past? Do you wish you had purchased more property in the past?
Historical data shows us that despite market fluctuations, GFCs, stock market crashes, recessions and global pandemics, property has continued to rise over the long term. The only question is whether you think it will continue to do this in the future? Will your children be asking why you didn’t buy more property when you had the chance?
Image: 16 Walker St recently sold for $8.1m – that’s quite a bit more than it was worth when initially purchased, don’t you think?
How Wealthy Investors Access Equity Without Paying CGT
Wealthy (and smart) investors don’t sell just to access money. Instead, they use their property’s equity.
Here’s an example.
- Let’s say your home is worth $1,000,000
- You owe $400,000 on the mortgage
- This means you have $600,000 in equity
Did you know that through refinancing, you could access (just as an example) up to $200,000 of this equity without selling the property?
Many lenders will allow you to access up to 80% of a properties value as long as you can show serviceability (that you can pay off the loan) and that you are using the money to purchase an investment.
That $200,000 of equity the bank just gave you can become the deposit on your next investment property.
No CGT event is triggered because no sale has taken place.
Leveraging Equity to Grow Your Property Portfolio
Let’s break down this strategy step-by-step:
- Access equity in your current property through a separate loan facility
- Use this as the deposit and costs for your next property purchase
- Get pre-approval, then take out an investment loan for the remainder of the purchase price
- Let both properties grow in value over time
- Then as these properties grow in value, you simply repeat this process as the equity grows again
| Item | Amount |
|---|---|
| Home value | $1,000,000 |
| Loan balance | $400,000 |
| Equity | $600,000 |
| Usable equity (80%) | $200,000 |
With $200,000, you could put that towards an investment property worth $900,000 (with the deposit and costs covered), plus, you keep your home.
Common Mistakes with Capital Gains Tax
So, now you’ve got the answer to the question “what is capital gains tax”. But before you get too excited and start having dreams of becoming a property investing mogul, it’s important to make clear that it’s not as easy as these numbers on a spreadsheet.
Buying and managing property is a difficult and technical process. However with the right expert guidance, the process becomes much more manageable.
As for CGT, here’s the most common mistakes we tend to see:
- Selling too soon: If you sell before 12 months, you don’t get the 50% CGT discount. This specifically applies to investors looking to “flip” or renovate a property. It’s important to know your position before getting started.
- Not tracking costs: It’s so easy to miss items on your spreadsheet. Forgetting to include stamp duty, legal fees and renovations in your cost base means you pay more CGT than necessary. Again, get a good accountant.
- Confusing CGT with other taxes: Understanding what is capital gains tax and how it is separate from stamp duty or income tax is vital. CGT is only calculated on your capital gain.
How to Minimise Capital Gains Tax
The easiest way to minimise CGT is to hold onto your investment property and never sell. This is how smart investors build wealth without triggering unnecessary tax.
If you do have to sell a property, having a good accountant that can walk you through the specific details and calculate all your deductions is crucial. You also need to make sure you understand the major rules, such as the 12-month ownership rules.
If you’re thinking about investing or want to understand your equity position, Indigo Finance can help. We’ll show you how to structure your loans, unlock equity and create a plan that sets you up for long-term success.
Click here to book a free strategy session with Indigo Finance today and see how your property could help you build the future you want. We can help you get a valuation on your family home and show you how much equity you could be able to access.
