Making sense of capital gains tax on shares

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 crazy as choosing an investment for tax considerations over the underlying merits of the investment itself.

With the new tax year still five months away, 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.

What is CGT?

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.

But 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, it’s better 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.

Don’t be stubborn

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 savvier 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 under-priced relative to intrinsic value.

First principles of capital gains tax

When it comes to capital gains tax, two overarching principles apply, these include:

A) Profits are only assessable when realised (subject to your marginal tax rate), and

B) 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.

What is the tax break?

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.

Tony earns $85,000 annually as a beekeeper. He buys 3,000 shares for $2.00, valued at $6,000 with brokerage paid separately on 20 July 2020.

The shares are trading at $4.00 throughout July 2021. If he sells his shares for $4.00 on 19 July 2021, 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 Tony held the shares for an extra two days and sold them on 21 July 2021 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.