- Investment strategies
- Why invest in the stock market?
- Buy and hold or technical analysis? Why you need an investment plan
- Value investing and short selling in volatile markets
- Using technical analysis to support value investing
- Investing in the unexpected
- Franking credits, explained
- What is dividend stripping and is it a sensible strategy?
- Investing in quality IPOs
- How to invest in stocks that benefit from a moving Australian dollar
- Reasons to avoid bonds when interest rates are low
- How value investors use Skaffold
- Quality, growth and value = a winning strategy
- Know your investor type and boost your performance
- Technical + fundamental analysis = better buy and sell decisions
- Fundamental investing
- Value investing and the price earnings ratio
- Intrinsic valuation models and methodology
- Value investments or value traps?
- How to find value stocks in a bull market
- Find value investments in expanding markets
- Why capital raisings struggle to add investment value
- How to value an insurance company
- Top stocks
- 5 qualities of top stocks
- How to find stocks with a competitive advantage
- Why return on equity is the best measure of business performance
- Using cash flow to find value investments
- Finding high quality dividend stocks
- Debt is not always a dirty word
- Why Skaffold share investment software makes sense
- Using economic factors to uncover the best investment options
- How do experts find top stocks to invest in?
- Investing in global stocks
- How to invest in international shares on global stock markets
- Benefits of investing in international shares
Capital gains tax on shares, explained
Some simple principles can help you avoid common mistakes with capital gains tax and maximise your after tax profits.
Refusing to lock in profits on a stock that’s become seriously overpriced just to avoid paying tax is as irrational as choosing an investment for tax considerations over the underlying merits of the investment itself. A short sighted approach to tax issues can undermine the integrity of your overall investment strategy as a value investor – and consequently your investment returns. We’ve identified the most common tax traps and how to avoid them.
Capital gains tax is triggered by investing success
While you should do your best to legitimately minimise the tax you pay on shares, it’s important to remember that paying tax is an unavoidable reality that is only ever triggered by your success as an investor. So if it’s right to realise a profit by selling shares, then pay the tax owing on it and move on.
This is how the real world works, and your core consideration as a successful investor should be what you’re left with after tax and not how much tax you’ll pay to receive the capital gain.
The refusal 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 companies that are overpriced in your share portfolio. Given that share prices eventually converge with intrinsic value, 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. Remember, companies won’t stay overpriced indefinitely, and certainly not without good reason.
Focus on the difference between price and intrinsic 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. And if you really are a value investor then you should be more attracted to paying tax on a profit than paying no tax on a loss.
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, then there’s little to be gained by selling for a tax deduction. It’s also important to note 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 – and as a value investor all the stocks in your portfolio should be when first purchased – then all you’re doing by selling is trading a tax deduction now for the opportunity of future capital gains once the share price corrects. Admittedly, while capital losses can be carried forward without time limits, it does make sense to post the 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. Most stocks that are significantly underpriced have become that way for good reason, and if the gap between price and intrinsic value is widening, not closing, then you’re better off selling up, accessing the loss and switching the funds into stocks offering superior investment opportunities.
Don’t ‘tax trade’
But don’t be tempted to ‘tax trade’ good stocks just so you can free up cash to pay an upcoming tax bill. It’s a much smarter strategy 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.
If you have no choice than to sell shares to realise cash to pay tax and no single stock in your portfolio looks particularly overpriced, then sell down your most over-valued stocks first and maintain your exposure to those looking the most underpriced relative to intrinsic value.
Principles of capital gains tax
Remember, when it comes to capital gains tax, two overarching principles apply, namely
1. Profits are only assessable when realised (subject to your marginal tax rate), and;
2. Losses on the disposal of capital assets are only deductible against capital gains and not against other income.
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. 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 per cent discount. But if you sell shares that you have owned for less than 12 months the full capital gain will be assessable for income tax purposes.
When lodging your tax return you will need the purchase and sale prices of shares you have sold in the previous financial year. Similarly, if you participated in a dividend re-investment plan you will find the purchase price of each parcel of shares on your dividend statement.
It’s true, you are not required to lodge an income tax return if you’re an Australian resident earning less than $6000, but you still need to apply to the ATO (with the appropriate form) to have your franking credits refunded.
How does it work?
Timing is everything when it comes to capital gains tax.
Simone earns $85,000 annually as a beekeeper. She buys 3,000 shares for $2.00, valued at $6,000 with brokerage paid separately on 20 July 2012.
The shares are trading at $4.00 throughout July 2013. If she sells her shares for $4.00 on 19 July 2013, 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 Simone held the shares for an extra two days and sold them on 21 July 2013 her assessable capital gain would be $3,000 as she’s entitled to the 50 per cent 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 Simone a nice tax saving of $1,110.