How to effectively apply capital losses

Understanding how capital losses are applied can help avoid making costly mistakes.

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Please note, the following is general information only and clients should obtain tax advice from a qualified tax agent to confirm their tax situation.

1. Capital Gains Tax indexation rule

Under the Capital Gains Tax (CGT) indexation rules, which do not apply to assets purchased after 21 September 1999, indexation of the cost base of investments held for at least 12 months is available before losses are applied to reduce the resulting capital gain. This means a client will obtain the benefit of indexation on an investment and the ability to apply the losses after indexation.

This, in effect, reduces the amount of losses needed to reduce the capital gain and allows the losses to be used against other capital gains or carried forward.

CGT indexation method
The formula for calculating a net capital gain or loss is:
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)

=

Net capital gain or loss

2. CGT discount rule

Another method for applying capital gains tax is the 50% discount rule for individuals, which again only applies for investments held for at least 12 months, where capital losses (current and net capital losses carried over from prior years) must be applied before the 50% discount is applied.

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

=

Net capital gain or loss

3. How to apply capital losses

It is necessary 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.

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 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. 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 oneInvestment A
Original cost of investment A $11,500
Net proceeds on sale of investment A $40,000
Assume 50% discount applies  
End of year twoInvestment C
Original cost of investment C $3,000
Net proceeds on sale of investment C (owned for less than 12 months) $16,000

Peter has the following choice with the disposal of investment B. Consider the following two options:

  • Investment B is sold by the end of year one for a tax loss of $10,000
  • Investment B is sold by the end of year two for a tax loss of $10,000

Calculation of capital gains

Option 1 – Investment B is sold by end of year one
Year one
Investment A
Year two
Investment C
Net proceeds 40,000 16,000
Cost (11,500)(3,000)
  28,500 13,000
Capital loss on Investment B (10,000) -
Net gain 18,500 13,000
Less 50% discount (9,250) -
Taxable gain9,25013,000
Total capital gain for year one and year two = $22,250
Option 2 – Investment B is sold by end of year two
Year one
Investment A
Year two
Investment C
Net proceeds 40,000 16,000
Cost (11,500)(3,000)
  28,500 13,000
Capital loss on Investment B - (10,000)
Net gain 28,500 3,000
Less 50% discount (14,250) -
Taxable gain14,2503,000
Total capital gain for year one and year two = $17,250

Please note: this example assumes that Peter’s level of taxable income, marginal tax rates etc are constant over the two years.

Under option 2, Peter will have $5,000 less capital gain to be assessed. The losses have been used in the most effective manner by offsetting against gains on an investment that has been held for less than one year and was achieved by not crystallising the loss in the first year. This allows the gain on the investment that has been held for more than one year to be discounted at 50% in year one.

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.

Realising 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 and disposing of an asset to reduce an assessable gain should not be the sole reason. Clients should 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 Tax Ruling 2008/1.

Tax issues can be complex, if in doubt, advisers should refer clients to a professional tax agent or an accountant.