While refusing to lock-in profits or never culling the deadwood from your share portfolio is one sure-fire way to avoid capital gains tax (CGT), it's as nonsensical as choosing an investment for tax considerations over the underlying merits of the investment itself.
With the new tax year having just begun, there’s no better time to take stock of the most common tax-traps share investors can easily fall into and the best ways to side-step them.
Capital gains tax is the by-product of making a profit
Legitimately minimising the tax you pay on shares is something every investor should strive for, and where necessary you should seek expert help to get it right. Like it or not, paying tax is a present reality resulting from the profit you’ve made by selling shares, so rather than agonising over it, pay the tax owing and get on with your next investment.
Instead of being fixated on how much tax you’ll pay to receive the capital gain, you’re better off focusing on what you’re left with after tax. Refusing to sell down a stock and lock-in a gain when you should – for example when it’s trading close to or above its intrinsic value – means you run the risk of retaining companies that are overpriced in your share portfolio.
Remember, share prices eventually converge with intrinsic value, so holding overpriced stocks not only means (potentially) missing out on large unrealised capital gains while they’re available, but also exposes you to future losses, especially if you’re sitting on potential value traps.
Don’t ‘tax trade’
It’s never a good idea to ‘tax trade’ good stocks with the express purpose of freeing up cash to pay an upcoming tax bill. The more savvy approach is to accurately calculate your capital gains tax position – using portfolio management software or similar – and ensure there’s sufficient cash put aside to cover it well before it’s due at the end of the financial year.
Assuming you have no choice other than to sell shares to realise cash to pay tax and no single stock in your portfolio looks particularly overpriced, it pays to sell down your most over-valued stocks first and maintain your exposure to those looking the most underpriced relative to intrinsic value.
First principles of capital gains tax
When it comes to capital gains tax, two overarching principles apply, these include:
- Profits are only assessable when realised (subject to your marginal tax rate), and;
- Losses on the disposal of capital assets are only deductible against capital gains and not against other income.
Remember, if your capital losses exceed your capital gains, or you make a capital loss in an income year and you don’t have a capital gain, you can carry the loss forward indefinitely and deduct it against capital gains in future years.
Since 19 September 1999, if you purchase shares and subsequently sell or transfer ownership after holding them for more than 12 months you are entitled to a 50% discount. But if you sell shares that you have owned for less than 12 months the full capital gain will be assessable for income tax purposes.
What you need when lodging a return
When lodging your tax return you’ll need the purchase and sale prices of shares you have sold in the previous financial year. Similarly, if you participated in a dividend re-investment plan you will find the purchase price of each parcel of shares on your dividend statement.
While you’re not required to lodge an income tax return if you’re an Australian resident earning less than $6000, you’ll still need to apply to the ATO (with the appropriate form) to have your franking credits refunded.
The workings
When it comes to capital gains tax, everything is dictated by timing, here’s an example of how it works.
Travis earns $85,000 annually as a lighthouse keeper. He buys 3,000 shares for $2.00, valued at $6,000 with brokerage paid separately on 20 July 2015. The shares are trading at $4.00 throughout July 2016. If he sells his shares for $4.00 on 19 July 2016, his assessable capital gain will be $6,000, i.e. $3,000 x $4.00 = $12,000 less what he paid for them which was $6,000.
If Travis held the shares for an extra two days and sold them on 21 July 2016 his assessable capital gain would be $3,000 as he’s entitled to the 50% CGT discount. This is because he held the shares for more than 12 months. Assuming he had no other capital losses or deductions, holding his shares for longer than 12 months has earned him a nice tax saving of $1,110.
Bigger capital gains
However, for those who bought shares many years ago, the tax issues resulting from sitting on big capital gains can be a lot more confronting.
For example, Damian bought a parcel of 10,000 shares at $2 each in January 2004, with brokerage of $350. Earlier this year, Damian sells the shares at $17.20 each, with a brokerage of $5200.
Damian has a realised holding worth $172,000 and a gain of $146,450 (taking into account both sets of brokerage fees). To keep it simple, let’s apply the discount method that applies to assets held for 12 months or more before being sold.
This allows shareholders to reduce their capital gain by 50% if they’re individuals (which include partners in partnerships and trusts) and 33% for complying super funds. Applying the discount method to Damian means 50% of the gain – or $73,225 – is assessable. This is taxable at his marginal tax rate, which depends on other income earned in the year.
For example, if he had no other income the tax would be $16,443. If jointly held with a spouse who also had no other income, each would pay $3602. However, if the shares were jointly held, both partners would share the gain 50/50.
If Damian earned $100,000 a year from other sources, his tax bill from the share sale would be $47,120. If he held the shares in his self-managed super fund, the same discounted method would be used but the gain would be taxed in the fund at 30%. Of course, if Damian has other shares that may be currently at a loss, he could also sell these in this financial year, crystallised the loss and use it to offset against this gain.
Differentiate between price and value
You’ll be less inclined to hold onto stocks due to tax considerations if you focus less on the price paid (and any tax due) and more on the difference between current price and estimated intrinsic value – which after all is the core tenet of value investing.
Remember that the tax argument for selling too late applies equally to selling too soon. If your initial justification for buying a stock still holds water, then there’s little to be gained by selling for a tax deduction. It’s also important to remember that good companies can, and often do, find themselves (albeit temporarily) underpriced due to macroeconomic conditions or industry issues beyond their direct control.
So assuming a good stock is underpriced, all you’re doing by selling is trading a tax deduction now for the opportunity of future capital gains once the share price corrects. Admittedly, while capital losses can be carried forward without time limits, makes good sense to post the gains and losses in the same year.
This is the time to cull the deadwood stocks that you’ve been reluctant to sell, before they further dilute the value of your overall share portfolio.
Remember, most stocks that are significantly underpriced have become that way for good reason, and if the gap between price and intrinsic value is widening, not closing, then you’re better off selling up, accessing the loss and switching the funds into stocks offering superior investment opportunities.
Investment expenses
Remember, you may be entitled to claim a deduction if you can show you incurred expenses earning interest, dividends or other investment income.
In addition to other asset classes, this may apply to your shares, and your expenses might include: Account-keeping fees for accounts held for investment purposes, management fees and fees for investment advice relating to changes in the mix of your investments, or interest charged on money borrowed to purchase shares or a rental property.
