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When you invest you make capital gains when asset values increase and capital losses when their values fall.
While the object of investing is to build your capital, the downside of making significant capital gains is that you can end up with a tax liability when the assets are sold.
When it comes to your SMSF, the right strategies can help you to effectively manage CGT within your portfolio and reduce its impact on your super balance.
What are capital gains and CGT?
Before rushing into the strategies, it’s worth quickly brushing up on the basics of how CGT works. CGT is part of the normal income tax of your SMSF (or of your income tax for gains you make outside super) and isn’t a separate tax. Under tax law, whenever you sell an asset and make a capital gain, you’re usually required to pay some tax on the capital gain you’ve made since purchasing the asset.
For example, if super fund A bought asset X three years ago for $100,000 but sells it for $120,000, the capital gain made on that asset is $20,000. Conversely, if the fund sells asset X for $80,000, it suffers a capital loss of $20,000.
When your capital gain is calculated, you’re permitted to offset it against any capital losses to determine your net tax position, on which the amount of CGT is calculated. Generally, there is no time limit on how long a capital loss can be held to offset future capital gains.
The ATO defines a net capital gain as:
- total capital gain for the year
- total capital losses for that year and any unapplied capital losses from earlier years
- CGT discount and any other concessions.
How CGT liabilities are calculated in an SMSF
During the process of buying and selling assets during a financial year, SMSFs usually generate both capital gains and capital losses. The CGT liability for any capital gain depends on whether the fund is in accumulation or retirement phase and whether there are fund members in each of those phases:
a. Accumulation phase CGT rules
If an SMSF is wholly in accumulation phase, it will pay CGT on the fund’s annual net capital gain. The net gain is treated as income for tax purposes, so it will be taxed at the same rate (15%) as other income in the fund. If an asset is held for more than 12 months, any capital gain is eligible for a discount of one-third, resulting in an effective tax rate of 10%.
Capital losses in SMSFs in accumulation phase can only be used to offset capital gains and cannot be used to offset any other income. A capital loss can be carried forward to future years in accumulation phase and used to offset capital gains at that time.
b. Retirement phase CGT rules
Because income earned in retirement phase is tax free, if the asset is sold in retirement phase, the SMSF will have no CGT liability on the capital gain.
Strategies for managing capital gains and losses in your SMSF
Strategy 1: Deferring capital gains until retirement
Deferring capital gains involves simply putting off the sale of an asset on which you expect to make a capital gain until all the members of the SMSF are in retirement phase.
Strategy 2: Using a capital gain to offset a capital loss
Capital losses from SMSF asset sales can be held until the fund experiences a capital gain. If the fund is expecting a capital loss in a particular year (such as from selling a poorly performing asset), it’s sensible to realise a capital gain in the same financial year.
This is very useful when all the fund members are getting close to retiring, as carrying forward capital losses is worthless when the SMSF moves wholly from accumulation to wholly retirement phase and becomes tax free.