Missing points in the CGT debate

I’m no tax expert, but one of the points that seems to be missing in commentary on the coming Capital Gains Tax (CGT) changes is that in the real world many investors currently don’t actually get the full benefit of the 50% CGT discount for realised gains on assets held over 12 months in many financial years.

The reason? They also have realised capital losses.

If your realised gains are all on assets held over 12 months, and you have realised capital losses in the same year, those losses need to be subtracted from your total capital gain BEFORE you apply a CGT discount and that discount can only equate to a maximum of half your NET capital gain. 

Therefore, a top marginal rate taxpayer will not be paying “only” 23.5% on those capital gains but an effective tax rate higher than this.

The inflation indexation approach obviously does not have such an adjustment because capital losses come off your total gain and then you subtract the inflation indexed cost base.

Put plainly, the existence of realised losses in a year impacts the effective tax rate you pay on the capital gains for the discount method but not for the indexation method.

Of course, those brilliant investors who only ever realise capital gains each year (on assets held longer than 12 months) and with no losses, do receive the full benefit of the 50% CGT discount.

In the real world though, in years with capital losses, the difference in tax payable on those gains between the discount approach and the indexation approach can be less, possibly significantly less, than most of today’s simplistic analysis suggests.

It also raises the tricky question of how capital losses would be dealt with under the rumoured hybrid discount/indexation approach for currently held assets going forward.

I am not arguing the case for either approach, but any assessment should start with the practical reality.

Under the rumoured hybrid discount/indexation approach for existing assets there may well be an incentive to realise significant recent years’ gains quickly before more of it is dragged into the indexation regime (especially if you expect lower capital gains going forward). This could well be a factor weighing on the local market now and in the near term. 

However, for most diversified, longer term focused investors, the difference between the two approaches over multi-year time periods is likely being exaggerated. Partly because of realised losses over time as discussed above and depending on the inflation rate.

Residential property investors and especially short/medium-term property flippers may be disappointed with lower after-tax returns, but if property delivers what it should long term - capital growth broadly around inflation - the CGT payable under indexation should not be a burden. 

It is possible that reduced attractions of property investment (and limitations on negative gearing) could see prices fall, depending on what happens with new supply ... which may be assisted by the possible carving out of these from new rules.

Still, more complete and robust property reform is only possible if it deals with some of the distortions around the primary residence (such as the overly generous treatment of significant housing wealth for pension and aged care eligibility and consideration of broadening land tax and/or applying CGT above a certain threshold).

To the point of most controversy, I can certainly empathise with those business founders/startups who put their life and money into one asymmetric, risky bet, where the mathematics of removal of the 50% CGT discount and adoption of the indexation method seems particularly harsh.

If, as is rumoured, the government is considering letting investors in new properties keep the 50% CGT discount to encourage new supply, why not also consider doing so for new/start-up businesses to encourage the innovation and other economic benefits they bring?

Anyway, let’s see what is announced on Budget night, and then what ends up being actually implemented over time.