Refusing to lock in your profits or never culling the underperforming shares from your ASX portfolio is certainly one way to avoid paying capital gains tax (CGT). But it’s as ill advised as choosing an investment for tax considerations over the underlying merits of the investment itself.
With the new tax year now upon us, there’s no better time to take stock of some gnarly tax-traps that investors can easily fall into.
It’s ok to give up some CGT, it means you’ve made a profit
Legally reducing the amount of tax you pay on shares is something I think every investor should aim for, and, where necessary, it makes sense to seek expert help to get it right. Like it or not, paying tax comes from the profit you’ve made by selling shares. In my opinion, it’s best not to sweat it, pay what you owe and get on with your next investment.
So, instead of fixating 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 shares and lock in a gain when you should – for example when it’s trading close to or above its intrinsic value – means you might end up holding on to companies that are overpriced.
It’s important to note that share prices eventually converge with intrinsic value, so by holding on to overpriced stocks you risk (potentially) missing out on large unrealised capital gains while they’re available. It may also expose you to future losses, especially if you’re sitting on potential value traps.
Don’t ‘tax trade’
I don’t think it’s a great idea to ‘tax trade’ good shares with the express purpose of freeing up cash to pay an upcoming tax bill. The smarter approach is to accurately calculate your capital gains tax position – by using portfolio management software or seeking expert advice – and ensure there’s sufficient cash put aside to cover it, well before it’s due at the end of the financial year.
But if you’re left with no choice other than to sell shares to pay tax and no single stock in your portfolio looks particularly overpriced, in my opinion it pays to sell down your most over-valued shares first. This means you’ll maintain your exposure to the ASX shares that look the most under-priced, relative to their intrinsic value.
The golden rules of CGT
When it comes to CGT, it’s important to recognise that 2 overarching principles apply:
- Profits are only assessable when realised (subject to your marginal tax rate)
- Losses on 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 you don’t have a capital gain, you can carry the loss forward indefinitely and deduct it against capital gains in future years.
The CGT discount
Since 19 September 1999, if you purchase shares and then sell or transfer ownership after holding them for more than 12 months, you’re entitled to a nice 50% discount on the tax payable. However, if you sell shares that you’ve owned for less than 12 months, the full capital gain will be assessable for income tax purposes.
What you need when lodging a return
When lodging your tax return, you’ll need the purchase and sale prices of shares you have sold in the previous financial year. If you participated in a dividend reinvestment plan (DRP) you will find the purchase price of each parcel of shares on your dividend statement.
You may not be not required to lodge an income tax return if you’re an Australian resident earning less than $6,000. But you’ll still need to apply to the ATO (with the appropriate form) to have your franking credits refunded.
How CGT is calculated
When it comes to CGT, everything is governed by timing. Here’s an example of how it works.
Belinda earns $85,000 annually (which puts her on a marginal tax rate of 34.50%). She buys 3,000 shares for $2.00, valued at $6,000 with brokerage paid separately on 20 July 2015.
The shares are trading at $4.00 throughout July 2016. If she sells her shares for $4.00 on 19 July 2016, her assessable capital gain will be $6,000: i.e. $3,000 x $4.00 = $12,000, less what she paid for them (which was $6,000).
If Belinda held the shares for an extra 2 days and sold them on 21 July 2016, her assessable capital gain would be $3,000 as she’s now entitled to the 50% CGT discount. This is because she held the shares for more than 12 months. Assuming she had no other capital losses or deductions, holding her shares for longer than 12 months has earned her a nice tax saving of $1,110.
However, it’s important to note that when there are other capital losses or deductions, or if a share is held jointly with a spouse (on a different marginal tax rate), the tax savings will depend on a number variables unique to each individual investor/s.
Distinguish between price and value
You’ll be less hung up about holding onto shares 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 of your shares. This is regarded as the core tenet of value investing.
Remember, the tax argument for selling too late applies equally to selling too soon. If your initial justification for buying an ASX share still holds water, then there’s little to be gained by selling for a tax deduction.
It’s also important to remember that good companies can find themselves (albeit temporarily) under-priced due to macroeconomic conditions or industry issues beyond their direct control (like COVID-19). So assuming a good share is under-priced, all you’re doing by selling is trading a tax deduction now for the opportunity of future capital gains once the share price corrects.
Investment expenses
Remember, you may be entitled to claim a deduction if you can show you incurred expenses earning interest, dividends or other investment income.
In addition to other asset classes, this may apply to your shares.
Your expenses might include:
- account-keeping fees for accounts held for investment purposes
- management fees and fees for investment advice relating to changes in the mix of your investments
- interest charged on money borrowed to purchase shares or a rental property.
Foolish takeaway
Instead of getting caught up in avoiding CGT, in my opinion it’s more important to consider if you need to cull the underperforming shares you’ve been reluctant to sell – before they dilute the value of your portfolio even further.
Remember, most ASX shares that are significantly under-priced have become that way for good reason. So if the gap between price and intrinsic value is widening, not closing, then you’re better off selling up, accessing the loss, and switching your funds into shares that offer superior investment opportunities.
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Motley Fool contributor Mark Story has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.
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