If you have made a significant capital gain during the year, as we come towards the final few months of the financial year, is it time to crystalize a capital loss?
By way of background, although capital gains are added into the rest of your income (e.g. salary and wages) and taxed at your marginal tax rates, capital losses from current or prior years are quarantined from the rest of your income, and can only be used to offset capital gains. By realising a capital loss, you can significantly reduce the tax payable made on a gain and therefore improve your year-end tax position.
For example’s sake assume you are on track to earn $120,000 in taxable income in 2020/2021. Back in 2009, you invested in two holiday apartments at the Sunshine Coast. You also have a vacant block of land in Emerald purchased during height of the mining boom for $300,000 that is now worth just $260,000.
Nearing retirement, you sell one of your Sunshine Coast apartments, and move into the other. After applying the 50% discount, assume you make a capital gain of $50,000. You then approach your advisor who outlines two alternative scenarios for you:
Retain both properties, and add the $50,000 capital gain to the rest of your income and pay tax on it at marginal rates in this case 37%. This would result in a tax bill of $18 500.
Sell the property in Emerald and use the capital loss of $40,000 to reduce your gross capital gain of $100,000 down to $60 000. After applying the 50% Discount, the net capital gain would be $30,000. At 37%, the tax on the capital gain would be $11 100. This represents a massive $7,400 tax saving.
In considering the above strategy (i.e. ctystalising capital losses to reduce capital gains), you also need to consider:
- The capital growth prospects of the loss asset. Many taxpayers are loathe sell assets for a loss, and will hang onto them hoping that the market turns. However, if the growth prospects of your asset are bleak, then crystalising the capital loss may be prudent. Turning to the above example, you may consider that now the mining boom has passed, the property has very little prospect for capital growth in the short to medium term, and that therefore the capital loss could be put to better use by reducing your tax bill by more than $7 000. Similarly, if you are holding onto shares that you consider now have little prospects of growth, crystalising the capital loss to reduce a current year capital gain may be a better use of that asset.
- The ongoing income from the asset. Although your loss asset may have depreciated in value, it may nonetheless provide you with a steady stream of income e.g. rental properties or shares where the company pays regular dividends. If this is the case, then carefully consider the impact that the forfeiture of this income stream would have on your budget if you were to dispose of the asset. Turning to the earlier example, this factor would be irrelevant as the land was vacant and was not generating any income. The same may be said for shares that you own in companies that rarely, if ever, pay a dividend.
Talk to your advisors if considering this strategy.