While refusing to lock-in profits or never cull 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 just around the corner, 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 paid on 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 profits 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 overpriced companies in your share portfolio.
Remember, share prices eventually converge with intrinsic value.
As a result, 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 wise idea to "tax trade" high-quality stocks to free 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 but to sell shares to realise cash to pay tax, one strategy is 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 CGT
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).
- Losses from 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 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 owned for less than 12 months the full capital gain will be assessable for income tax purposes.
The workings
Capital gains tax is dictated by timing. Here's an example of how it works. Travis earns $85,000 annually as a lighthousekeeper. He bought 3,000 shares for $2.00, valued at $6,000 with brokerage paid separately on 20 July 2023.
The shares trade at $4.00 throughout July 2024. If he sells his shares for $4.00 on 19 July 2023, 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 2024 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 earned him impressive tax savings of $1,110.
Price versus 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, there's little to be gained by selling it for a tax deduction. It’s also worthwhile 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 future capital gains once the share price corrects.
Admittedly, while capital losses can be carried forward without time limits, it makes sense to post 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 an obvious reason. If the gap between price and intrinsic value is widening, not closing, you're better off selling up, accessing the loss and switching the funds to stocks offering superior investment opportunities.
Investment expenses
Remember, you may be entitled to claim a deduction if you can show you incurred expenses to earn 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.
- 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.
Listed funds with tax-free capital
While now closed to new registrations, there are four remaining ASX-listed stocks which under the Federal Government's Pooled Development Funds (PDF) program provide tax advantages to registered venture capital funds investing in early stage businesses.
While funds pay a reduced rate of tax (15%) on income and capital gains received from their investments, shareholders in a PDF are also exempt from tax on both their income (dividends) and gains, provided certain requirements are met.
Admittedly, the tax treatment is unique and somewhat complicated, and these early stage businesses come with a high degree of risk.
The four stocks under the PDF program include:
- Acrux (ASX: ACR). Market cap $10 million, share price is down 53% in one year and 27% year to date.
- BioTech Capital (ASX: BTC). Market cap $17 million, share price is up 22% in one year and down 24% year to date.
- MEC Resources (ASX: MMR). Market cap $7 million, share price is down 20% year to date.
- Strategic Elements Ltd (ASX: SOR). Market cap is $20 million, share price is down 41% in one year and down 10 years to date.
This article does not constitute financial product advice. You should consider independent advice before making financial decisions.
