A few weeks ago we wrote about income return – the return you get while you continue to hold an investment asset. This week, we turn our attention to capital return – the return you don’t get until you sell your investment asset.
The first thing to remember about capital return is that it does not happen until you ‘dispose’ of an asset. This will usually be when you sell the asset, but a disposal can also occur if you simply transfer ownership of an asset from one ‘legal person’ to another. For example, if a businesswoman transfers shares from her own name into a family trust, this is classed as a disposal from her personal point of view, even if no money changes hands.
More often, though, the capital return is realized when an asset is sold. This is why capital return is all about the future. While an investment is still being held, it is possible to know that an investment has risen in value. For example, if I buy shares in an ASX 50 company for $10 on 1 July, and by August 12 the market price for those shares has risen to $12, then I know that I could sell those shares today for $12. In one sense I have made a capital gain, but the gain is as yet unrealized. Of course, because it is unrealized, it could evaporate before I have had a chance to sell the asset. That is, prices could fall back to $10 or even further tomorrow, in which case I have an unrealized capital loss.
Different assets provide a different mix of capital and income return. Investors who currently need money to finance their lifestyle will tend to prefer investments more skewed towards income return, so they can receive money in the relatively short term. Investors who do not currently need investment returns may prefer investments more skewed towards capital return, which can be received at some time in the future.
A classic example is an investor who borrows money to buy a residential investment property. Residential property tends to provide a higher proportion of the overall return in the form of capital growth over time. The average gross rental yield for residential property around the country is just over 3%. Given that interest rates are in many cases higher than this, and investors have other costs such as insurances, rates, repairs, etc, a property investor who borrows to invest in residential property will often actually lose money while they hold the investment. This is known as negative gearing.
For a person to be able to afford negative gearing, they need to have other money available to make up the loss while they hold the asset. And a person would only pursue negative gearing if they expect that the capital return over time will be more than offset the loss they are making today.
Benefits of Capital Return (versus Income Return)
There are two main benefits of capital return. The first is that capital return is not taxed until the return is actually realized. This is because tax does not apply until you receive your money. With an income return such as monthly rent, you receive money every year and so you pay tax every year. But you do not receive the money from capital return until you dispose of the asset. This allows the money that would otherwise be paid as tax to remain ‘in’ the investment, allowing you to generate returns on it.
This becomes particularly advantageous if you hold the investment for more than 12 months. Depending on what type of investor you are, doing so usually reduces the amount of tax you pay on the capital return. If you invest in your own name or in the name of a company or a trust, then there is a 50% discount on the tax payable. For example, if you buy an investment for $1,000, hold it for one year and one day and then sell it for $1,100, you have made a $100 capital gain. But, only $50 of this gain will be taxed. Half of the gain is tax-free.
If you invest through a super fund, then you usually get a 33.3% discount on tax payable if the asset is held for more than 12 months.
This discount is related to the second benefit of capital returns over income returns. You can usually choose the time at which you realise a capital gain because you can usually choose the date at which you sell an asset. This lets you choose to sell the asset after holding it for more than one year. But it also lets you – ideally – choose to sell the asset in a tax year when your other income is low. This is helpful because the discounted capital gain is added to your income in the year in which the gain is realized. So, the actual tax paid on a gain depends on your other income in that particular year. If that income is low, then less tax is paid.
This can be quite a perk. You might own an asset for 20 years. But the tax on the gain will depend on how much money you make in the year that you sell it.
As an example, suppose an executive has a salary of $200,000 a year. She also has a portfolio of shares in her own name with an unrealized capital gain of $200,000. If she sells the shares in a year when she is working, then (using current tax rates), she would pay $45,000 in tax as a result of the gain. (If you want to work this out: the gain is $200,000. There is a 50% discount, so only $100,000 is taxable. The executive already has income of $200,000, so her tax rate on any extra money is 45%. 45% of $100,000 is $45,000).
If, instead, the executive decides to retire on 30 June and then sells her shares on July 1, which is a different financial year, and then does not do any other work during that tax year, her only income for the year will be the $100,000 in discounted capital gains. The tax on this is only $22,967. So, by timing the sale of the shares for a time when her income is otherwise low, the executive pays less in tax.
So, capital returns let the investor pay less tax because of the discount, and then gives them a further opportunity to save tax by timing the sale of the asset. Accordingly, capital returns are often preferred by investors with high incomes from sources other than their investments, such as a salary.