Capital losses – applying them effectively

By William Truong, Technical Services Manager

Understanding how capital losses can be applied can help to reduce assessable net capital gains. 

While your clients should always obtain tax advice from a qualified tax agent, the following article can help you understand the rules. 

1.  CGT discount rule - 12-month ownership

For assets held for longer than 12 months, the 50% discount to capital gains realised applies. 

Before applying the 50% discount, capital losses (including capital losses carried over from prior years) must be applied first.

The formula for calculating a net capital gain or loss is:

CGT discount method    
Capital gains for current year, less
Capital losses for current year (if any), less
Net capital losses carried over from prior years, less
Applicable CGT discount 
equals Net capital gain or loss

2.  Capital Gains Tax indexation rule

As an alternative to the 50% capital gains discount, assets acquired prior to 11.45am on 21 September 1999, can apply the Capital Gains Tax (CGT) indexation rule instead. 

Under the CGT indexation rule, indexation of the cost base is available before losses are applied to reduce the resulting capital gain. This means that your client can obtain the benefit of indexation on an investment and the ability to apply the losses after indexation, which can further reduce the capital gain. 

In other words, by first applying the indexed cost base, the capital gain can be reduced and can increase the effectiveness of applying losses. This can allow the losses to be used against other capital gains or carried forward to future years. 

The formula for calculating a net capital gain or loss is:

CGT indexation method
   
Capital gains for current year (takes into account the indexed cost base), less
Capital losses for current year (if any), less
Net capital losses carried over from prior years (if any) 
equals
Net capital gain or loss

3.  How to apply capital losses 

You need to apply any available capital losses for the current income year first and then any unapplied net capital losses for previous income years. 

The only choice that a client has in relation to applying losses is the ability to select which gains, assuming that a number of investments were disposed of in the same year, are to be offset against the available losses. 

This is important as losses are best utilised by offsetting (where possible) against gains on investments owned for less than 12 months before using gains on investments owned for more than 12 months.

Tech tip: When applying your current year capital losses, you can choose the method that gives you the best result to reduce your current year capital gains. 

Generally, the order that usually gives the smallest net capital gain is to apply the capital losses against capital gains calculated using the:

  1. 'Other' method (investments held for less than 12 months)
  2. Indexation method (assuming this method is chosen)
  3. Discount method

Please note: the discount method generally results in a smaller assessable gain than the indexation method. 

However, when there are gains and if both the indexation method and discount method are chosen, losses should be applied to the gains relating to the indexation method first.

The following example shows when capital losses are more effective in one year over another depending on realised gains on assets held for less than 12 months. 

The timing of any sale should never be solely based on tax outcomes as considerations such as cashflow needs and the appropriateness of the investment will likely have a greater bearing on any choice to dispose of an investment.

Example

Peter acquired and disposed of his investments as follows:

 End of year one ABC Pty Ltd
Original cost of ABC Pty Ltd $11,500
Net proceeds on sale of ABC Pty Ltd $40,000
Assume 50% discount applies   
   
 End of year two  XYZ Pty Ltd
 Original cost of XYZ Pty Ltd  $3,000
 Net proceeds on sale of XYZ Pty Ltd  $16,000
Owned for less than 12 months - no 50% discount available  

Peter has the following choice with the disposal of Lemon Pty Ltd. Consider the following two options:

  • Option 1 - Lemon Pty Ltd is sold by the end of year one for a tax loss of $10,000
  • Option 2 - Lemon Pty Ltd is sold by the end of year two for a tax loss of $10,000

Calculation of capital gains:

Option 1 - Lemon Pty Ltd is sold by end of Year 1

  Year one
ABC Pty Ltd
$
 Year two
XYZ Pty Ltd
$
 Net proceeds  40,000 16,000
 Cost  (11,500) (3,000) 
   28,500 13,000 
 Capital loss on Lemon Pty Ltd  (10,000)
 Net gain  18,500  13,000
 Less 50% discount  (9,250)  -
 Taxable gain 9,250  13,000
 Total capital gain for Year 1 and Year 2 = $22,250

Option 2 - Lemon Pty Ltd is sold by end of Year 2

  Year one
ABC Pty Ltd
$
 Year two
XYZ Pty Ltd
$
 Net proceeds  40,000 16,000
 Cost  (11,500) (3,000) 
   28,500 13,000 
 Capital loss on Lemon Pty Ltd  -  (10,000)
 Net gain  28,500 3,000
 Less 50% discount  (14,250) -
 Taxable gain 14,250 3,000
Total capital gain for Year 1 and Year 2 = $17,250 compared to $22,250 per Option 1.

Please note: Peter's actual tax liability will also depend on other variables, such as his level of taxable income, marginal tax rates and more over each individual financial year.

Under option 2, Peter will have $5,000 less capital gain to be assessed. The losses have been used more effectively by offsetting against gains on an investment that has been held for less than one year. 

Tech tip: Similar consideration should be given when there are multiple disposals in the same year, as it may be beneficial to match losses first against gains on investments that have been held for less than one year.

Conclusion

Applying capital losses in a year where there are gains on assets held for less than 12 months can be particularly effective in reducing net capital gains. There are many factors to consider when disposing of an asset. Disposing of an asset to reduce an assessable gain should not be the sole reason. 

You should encourage your clients to obtain independent tax advice. Please note that arrangements which involve the sale and repurchase of assets to create a tax advantage, such as a capital loss, may be caught under Part IVA (the general anti-avoidance rule for income tax). For more information refer to 'wash sales' in Tax Ruling 2008/1.


More information

If you have any questions, or would like more information, please contact the IOOF TechConnect team on 1300 650 414.

Disclaimer
The information in this section of the website is intended for financial advisers only and is not to be distributed to clients. It has been prepared on behalf of Australian Executor Trustees Limited ABN 84 007 869 794 AFSL 240023, IOOF Investment Management Limited ABN 53 006 695 021 AFSL 230524, IOOF Investment Services Ltd ABN 80 007 350 405, AFSL 230703 and IOOF Ltd ABN 21 087 649 625 AFSL 230522 based on information that is believed to be accurate and reliable at the time of publication.