The tax value of deferred capital gains

There has been great public discussion of tax changes in the 2026 Federal Budget.

Apparently, the sky will fall in.

The sky has fallen in if you made a living as a professional tax adviser.

For everybody else, the important business of wealth compounding goes on whatever the tax regime, ever and always in the same way. 

Choose growth assets over income and take that zero interest free loan from the government to finance your future tax liability.

If you understand the value of tax deferral, you will do fine.

If you do not, get your tax adviser to find new ways to lose you money.

If you want to reduce your tax bill to zero, then earn no income.

You did not have to pay me anything for that free tax advice.

Read on to grow your wealth and not that of your tax adviser.

The investment game is ever and always about the mathematics of compounding.

It is both subtle and powerful, with some hidden surprises.

The Eighth Wonder of the World

Compounding is powerful because it involves geometric growth:

Compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn’t... pays it. - Albert Einstein

Whether Einstein actually said that we don't know. However, he would understand it.

Let us understand this principle better in relation to taxation effects.

Across the globe, while tax rates differ, one truism remains:

Income is generally taxed in the year you make it whereas capital gains are taxed in the year in which you realize the gain by selling.

I am a licensed wealth adviser, not a licensed tax adviser.

I almost never use tax advisers because of one simple fact:

Investment gains are the source of wealth gains and tax strategies are generally hostile to gains and involve schemes to make losses to offset income. Losses do not interest me. They are simply a drag.

How then do I combat high marginal rates of PAYG taxation in Australia?

The answer to this is two-fold:

1. I stopped being a PAYG wage-slave as early as possible in my 48th year.
2. I learned how to invest my own capital and defer taxes by holding long-term

As you will see in the simulations below, there is a very great advantage to minimizing your trading activity and holding growth assets for the long haul. 

Now I am 63 years old, and the strategy is paying off. 

Every recent large purchase I made, residence, car, etc, was from cash.

I have not had a mortgage since I turned 33 and have not looked back.

In case you are wondering, I rented. I realized I would do better in the share market.

Our household has zero debt except for the usual credit card revolver. I am happy to pay my credit card fee because I never pay any interest on my card balance. 

I always pay off my credit card in full.

I do not count as rich, by any normal standard, but I am doing okay.

I have founded five companies in my lifetime but retain just one operating company.

The prospects for that business look better post the Jim Chalmers tax changes.

This may surprise some readers, but it is true.

I am a licensed wealth adviser not a licensed tax adviser.

I care about making gains, not minting losses to minimize tax.

The prospects for people who can surface positive money-making investments have just gotten wildly better after these tax reforms. You will see why below.

Even though tax rates have gone up the opportunity for capitalism improved.

That is because the old system favored the rentier class of landlords.

The new regime is in transition, but it definitely favors entrepreneurs.

That is because the capitalist entrepreneur has many mouths to feed:

• Employees via wages
• Service providers via fees
• Financiers via rates of interest
• Landlords via rents
• Governments via taxes

Every one of these factors of production is a cost to the entrepreneur.

The true capitalist must work hard, in their business model and capital stock selection, to offset each of these cost headwinds to deliver value and earn a profit surplus. That is their reward for organizational skill and verve.

There are people who would like entrepreneurship to be easy:

• Give me free land.
• Give me tax holidays.
• Give me free finance.
• Give me free services.
• Give me wage slaves who must work to afford high rents.

People with no genuine entrepreneurial drive want a free ride.

Where the real free ride comes from is land ownership.

Everyone who makes an effort to grow the economy, and increase the wealth and prosperity of society at large, makes the value of unimproved land increase. 

The free ride comes from an entirely passive role in the ownership of land, without actually doing anything at all.

The American journalist and social commentator Henry George noted this mechanism and chose to popularize understanding of it in his book Progress and Poverty.

This book was very popular in Australia around the time of Federation. That was after the 1880s land boom, the one that produced the Marvellous Melbourne of my youth.

Recycled profits from the gold boom triggered land speculation. Historians will record, this is a prediction, that Australia had a similar land boom after 2001.

Why that year?

That was the year China entered the WTO, and we had easy money.

What nobody in government will ever say is that this is the reason we have the tax changes from Jim Chalmers. We are investors, not politicians, we can work it out.

If we run an investment fund, and cannot work this out, we die.

There will be another investment fund, who did work it out, and will thrive.

That is entrepreneurship. Roll with the punches. Work it out. Move on.

If you want to complain, and have a platform, work for KPMG.

In contemporary Australia, there is much discussion of the housing crisis. Everyone knows that we are not building enough houses, and that young people cannot afford to buy homes. This is presented as a mysterious problem that is likely the fault of central bankers or foreigners.

Contrarian investors are happy to court controversy in the service of reality.

Cue maximum tempo public controversy...

Earlier, I mentioned genuine capitalistic entrepreneurship, and the concern with factor values. The true entrepreneur depends on the cost of all inputs. The one that I pay most attention to, as a global investor, is the cost of land. 

The USA remains comparatively attractive, outside of major urban centers, because it has much more moderate site values. The USA is genuinely capitalist in orientation, with far less influence from rentiers, although it is deteriorating. I continue to like that market.

Australia, on the other hand, is not very entrepreneurial, in any meaningful way, and the story shows clearly in the oligopolistic structure of major industries in mining and finance, plus the remarkable rise in farmland values and residential real estate. 

Paced in terms of the passive numeraire of gold values, you can see all the classic hallmarks of a great monetary inflation.

Nothing heralds a boom like easy money and credit. The greatest gains fall to those who own the assets that benefit from money creation. In the early days of the boom, the uplift is very broad. In the later stages of the boom, it narrows. Eventually, there is a bust.

This is Political Economy 101, as per the classic by David Ricardo.

This post began with a discussion of the tax value of deferred capital gains. We will return to the topic, in earnest shortly. However, what happens next in the Australian economy is not likely to be foreseen, unless one understands where the unrealized capital gains lie.

Ever and always, you will find unrealized capital gains in the share market.

Twenty-five years ago, I developed a method to measure them.

There are usually 10-15% unrealized capital gains in share markets, except during bear markets when they reach to around -40% of unrealized losses. That is why everyone is miserable.

What tends to happen in market cycles is that people reach for late gains in frothy conditions by selling good stocks to eke out more fleeting gains in promotional paper. This will always turn up, right on cue, late in a bull market. Judging from the SpaceX IPO, that time is now.

I will not get into this further today but note the other place where we have generational levels of concentrated capital gains: Australian residential real estate, which is unaffordable.

What changed with the Chalmers Budget was the merit of negative gearing for investment property. This is abolished for new investment, other than in new build, but grandfathered. Existing negatively geared real estate portfolios can continue, but the 50% CGT discount is being replaced on 1st July 2027. The Australian Treasury modelled a slowing in house price growth of around 2% over two years. They are economists, they probably believe that.

If you take a gander at the farmland values chart, and Australian residential real estate values chart this does seem like heroic "no change" forecasting from where I sit. Since I am an equity investor, of some three decades, I am unphased by a 50% drop in share prices.  A 10% drop in real estate values would be healthy. A 30% drop is likely needed to fix the market.

Needless to say, that would frighten folks.

It would not frighten me because I have no debt on my balance sheet.

If it happened, that would be very good for entrepreneurship, and it would boom. People would have to go out and work for a living instead of counting paper profits.

That may sound harsh to those under fifty years old.

Stick around for an object lesson in harsh:

More rational factor values for company formation are coming.

Post these changes we will have fewer over-compensated tax advisors.

In the museum, they will have a special wing for taxidermy displays of discretionary trusts.

You know, if you have been around the block a few times, that I am only half joking.

For those starting out in wealth accumulation your best income years are ahead of you.

What you will receive is free general advice on the tax value of deferred gains.

Pay attention if you wish. Don't if you prefer to join the crowd.

The Difference in Timing of Taxes between Income versus Growth

What I am going to describe is standard financial advice for those who went to school.

The key thing to understand about tax is that the timing of it.

• Income is taxed in the year that it is earned.
• Capital gains are taxed in the year that they are realized.

This makes all the difference on figuring out the after-tax rate of return.

If you are a professional tax adviser your benchmark is the tax dollars you saved for your client. If you are a professional wealth advisor your benchmark is the post-tax dollars you made for your client. These may seem like the same thing, but they are totally different.

You can always reduce your taxable income to zero by becoming poor.

One great way to start rich and die poor is to actively look for loss-making investments.

Sydney real estate is bought by negatively geared investors at gross yields of around 3-4% financed at mortgage rates of around 6%, for a negative carry at 80% equity of around minus 1% to 2%, exclusive of depreciation charges, that ought to run at 2% on structure, or 1% overall and agent fees of 0.5%.

This is losing money at a steady rate to reduce personal tax and enrich others.

Look at how much tax you saved to make your mortgage broker rich!

The constant drag of that negative carry goes out the door each year, every year, in the hope that you will sell one day and realize a fat gain, discounted at 50%, of course.

This is the game and it is a game.

In comparison, you could have invested in the Vanguard Total World Stock Index ETF back around 2-Jun-2008, in USD, because that is how it is quoted, reinvested dividends, and not sold any of it, paying Australian tax only on that portion of the dividend not covered by an annual refund of tax withholding, through your PAYG tax return. 

Your total pre-tax return over that period would have been around 532%. On whatever initial parcel you bought, at inception, you would have an unrealized capital gain of 332%. Nobody forces you to realize that gain. When you do, you will pay tax. You eat that.

Confusing huh? 

Damn, I made so much money I need a tax advisor to tell me how to lose some!

Alternatively, you could pay your taxes and move on to the next investment.

Should it be high growth, or low growth?

I paid so much tax last time, maybe I should go for lower growth and pay less tax.

I have seen this exact story play out so many times I can script the encounter.

Surely, I am better accepting lower returns to pay less taxes?

Modelling Income versus Capital Growth with Deferred Gains

These are not questions for social media.

Which is better: growth or income?

Do that and you are sure to find some amusing answers.

The question is mathematical and can be accurately framed to yield answers.

The result in question is this:

For any adjusted rate of return R >0 and tax rate T that is in the full range of 0% to 100%, the after-tax return of growth investment is better than or equal to that of income over any period.

That is what we will show (again because it is an ancient result).

Let me first break it down.

For any fair comparison, you need to compare apples with apples. Some income comes with attached tax credits, like franked dividends. You need to gross those up for the tax value you can use to offset tax liabilities as they fall due. At the 30% Australian corporate tax rate, the grossed-up value of 5% fully franked dividends is 7.14% (5%/ (1-30%). The same is true of capital values for some shares in some jurisdictions. You may receive returns of capital, which are not taxed in the year you receive it, but which lower the cost basis of shares. This has the effect of shifting the tax of that capital return into the future when you sell the shares.

Spend thirty years in global markets buying and selling shares across forty markets and you will find all kinds of tax differences and wrinkles on return calculations. I am not pretending that these are unimportant. I am just sweeping it under the rug of "adjusted return R".

Adjusted returns are like pornography. Hard to define but you know it when you have been through the prospectus a million times and need a drink.

The tax part is easier to explain:

After Tax Proceeds = (Pre Tax Proceeds) x (1 -Tax Rate)

Following the Chalmers Budget changes these are the same for income and growth. The former 50% discount for long-term gains has gone, so the tax on capital has gone up.

The challenge for the investor is what to do in the new situation.

Superficially, it may seem that you need to change your attitude to growth over income. I can understand this perspective. Some people think it is simple: just choose the lower tax rate. With this mental shortcut in mind, of course you used to prefer growth, taxes were lower.

Tax rates rose, on long-term growth, maybe I should change my preference?

Superficially, yes, but factually no. 

Let us see why compounding and tax-deferral changes the game.

We have to model multiperiod investing with deferred capital gains.

After-Tax N-period Return on Income

The tax on income hits cashflow at every year-end which makes it simple.

The after-tax compounding factor for wealth is the pre-tax return multiplied by the income you retain after paying tax. This is 1 - T, where T is the tax rate. The N-period return is then:

This model fits the intuitive result for tax rates. The rate of return goes down by the tax rate.

After-Tax N-period Return on Growth

For growth, the story is different, because deferred gains trigger taxes after the sale.

What you find is that the pre-tax capital compounds annually at the higher rate of R but then gets a haircut by the full tax rate applied to the totality of the potentially large gain.

 The Miracle of Compounding

It can be difficult to accept, but the following statement is always true:

The strategy of letting the tax liability grow over time, only to pay your taxes at the end, in one great lump, actually leaves you better off, in after-tax dollars, than the pay as you go.

This mathematical result is true for all R>0, all periods N, and any feasible tax rate T, between 0% and 100%. You are never worse off in the deferral strategy, and you are usually better off.

The statement "usually better off" is always true when T is not zero.

If the tax rate is 100% you should not invest!

This is standard, but widely unknown, except to long term wealth accumulators.

The poof is standard, and I repeated it here.

What about Entrepreneurship?

There are many who responded to the tax changes in horror.

What is a growth-oriented entrepreneur to do now?

The exact same thing any real entrepreneur has always done:

Solve a useful problem, build value, hold for the long haul.

Jensen Huang, CEO of NVIDIA, founded the company with friends in 1993. They solved a real problem in computer architecture by inventing the Graphics Processing Unit (GPU). He is still running the company he, and his buddies, founded. Through thick and thin. He is there.

I ran a simple simulation over ten years at different growth rates.

What you can see with this table is that PAYG strategy of paying taxes out of declared income every year is arithmetically driven by the tax rate. You retain 51.5% whatever the growth rate.

This changes when you switch the deferral of capital gains. Your rate of return is higher, and the share of the pre-tax return that you see is higher. For Unicorn growth of 100% you get 87.18%.

I could go on, but I won't. You get the picture.

Defer gains and exercise patience.

In the coming deleveraging of poorly constructed negative carry real estate portfolios stand back until the dust has settled. You understand compounding. Take advantage of it.

Forty years of capital misallocation is now set to unwind.

This is best for young entrepreneurs.

It is also good for young workers.

Grasp the opportunity of your lifetime because it is coming.