Tax saving strategies for share investors to legally pay less tax

In this article, we will explore some of the tax saving strategies available to share investors.

Share investors have their own set of tax rules, which if executed carefully, can help you legally reduce your tax.

Remember, it’s okay to pay tax. After all, paying tax is a sign of success.

If you’re a successful investor, you’re going to pay some tax along the way. But that doesn’t mean you have to pay more than your fair share.

Use these tips to reduce your tax bill…legally!

50% Capital Gains Tax discount

Let’s start with the basics and make our way from there.

If you hold your investment for more than one year, you are generally entitled to a 50% discount on the capital gain.

Let’s say you bought an investment for $5,000, and the value of the investment increased to $8,000. The capital gain (the appreciation in the value of the asset) is $3,000.

If you sell this investment within a year of buying it, this $3,000 will be taxed at your marginal tax rate.

However, if you sell this investment after one year of buying it, you generally receive a 50% discount, and only $1,500 needs to be declared as income in your tax return.

The idea behind the 50% discount is that over time, inflation makes up a substantial proportion of your ‘capital gain’, rather than an increase in the value of the underlying investment itself.

This can certainly be true for long-term investments, but for investments owned over a shorter period of time, you can use this rule in your favour to reduce the tax payable on your profit by half. Not bad at all.

Tip: when determining whether the investment has been held for more than one year, it’s the contract date that’s important, not the settlement date. You need to hold the investment for a full year to qualify for the 50% CGT discount, so add a few days either side to be safe.

Specific identification method

Often, an investor may have bought multiple parcels of shares in the same company over a period of time.

When an investor sells a parcel of shares, it’s not uncommon for them to assume the calculation of the capital gain must be completed on a ‘first in, first out’ basis.

However, the ATO allows you to identify the particular shares you have disposed of, provided you have the relevant records, such as share certificates.

Here’s an example of how this may play out in the real world:

Joe Bloggs purchases two parcels of shares - one parcel of 5,000 shares which cost him $2 per share, and one parcel of 5,000 shares which cost him $10 per share.

The shares are currently valued at $15. Joe wants to free up some cash, and decides to sell 5,000 shares. To reduce his tax bill, he elects to treat the second parcel of shares as the parcel of shares being sold. This results in him declaring a capital gain of $25,000, much less than the capital gain of $65,000 he would need to report if he used the ‘first in, first out’ methodology. Joe has the necessary records to make this choice in methodology.

Use debt wisely

While I wouldn’t necessarily recommend borrowing to invest in shares, you can use debt wisely to minimise your tax payable, while keeping your total asset position the same.

Most often, this is as simple as paying down non-deductible debt and then increasing deductible debt.

This may best be illustrated by way of example.

Mary Bloggs has $25,000 in cash saved up, and decides she wants to start investing. She has a home loan but decides she wants to invest the $25,000 directly into the share market, which earns 4% dividend income earn year. She pays tax on this amount, diluting her after tax return on her investment income.

Alternatively, Mary could have used the $25,000 to reduce her non-deductible home loan debt by paying this amount off her home loan, and then asking her bank for a new, separate loan for $25,000.

Mary’s bank grants her the loan, and charges her the same interest rate she was paying on her mortgage. Mary then uses this $25,000 loan to buy shares. Under this option, Mary’s debt and asset position has remained the same, but she now will receive a deduction for the interest charged on her $25,000 loan, as it has been used to acquire an income producing asset.

If the loan is at 4%, this means her dividend income will effective be tax free! This is because her dividend income is now offset by deductible interest. All it took was a little bit of work to organise a new loan and she has increased her tax effectiveness significantly.

Shares bought prior to 20 September 1985 are likely to be tax free…until you die

For investments bought prior to 20 September 1985, these will generally be tax free.

There is however a range of events that can happen, which could result in your asset no longer being tax free.

After all, it’s in the Government’s best interests to bring more assets into the Capital Gains Tax regime - they can collect more revenue that way.

One of the events is passing away. When you die, your assets will pass to your beneficiaries in accordance with your Will.

For assets acquired before CGT was introduced on 20 September 1985, these assets will become taxable when you pass away, and your beneficiaries will have to pay Capital Gains Tax on the appreciation in the value of these assets, based on the difference between what they are deemed to have acquired them for and the amount they sell it for. For assets acquired by the deceased prior to 20 September 1985, the recipient beneficiary is typically deemed to have acquired the asset for its market value on the date of your passing.

Therefore, you can potentially avoid a CGT liability by selling these shares while you are still alive, because they won’t be taxable for you. Have deep and frank discussions with your beneficiaries - they might not even want to inherit those assets. If not, it might be advisable to dispose of them while you are still alive (the investments, not the kids I mean).

Structure your investments

Before you start investing, think carefully about which entity you are buying the investments in. Doing so can help you save a considerable amount of money.

The three most common ways to buy shares are as follows:

1. In your own name (i.e. as an individual shareholder). In this case, the income you receive is added to your other income and taxed at your marginal rate. For some people, this might be as high as 47%. If you are in a relationship, at the bare minimum, please buy the investments in the name of the person that earns the least amount of income. Take advantage of their lower taxable income and pay less tax.
   

2. In a trust. The benefits of owning the shares in a trust is that each year, you have the flexibility to distribute the income to a variety of beneficiaries. This gives you options. Say you decide to have a baby and don’t work for two years, the trust could distribute the income to you to take advantage of your lower taxable income for those years. Or your partner might lose their job and not have an income for a period of time. That’s the perfect opportunity to distribute investment income to that person. This flexibility just isn’t available if you hold the shares in your own name. When you own the shares in your own name, you pay the tax, and no one else.
   

3. In your superfund or SMSF: Your superfund is one of the best places to invest, as your investment returns are generally only taxed at 15%. The problem with super is that you won’t be able to access your funds until 60 years of age for most people. Also, a typical retail superfund might not allow you the flexibility to invest in a variety of assets, so a Self-Managed Super Fund might be best. If you have a long-term horizon, using your super to invest can be one of the best ways to accelerate your wealth.

Franking credits - 45 day holding rule

When you’re investing in shares, there’s a good chance you’ll receive dividends along the way. And most dividends come with franking credits. Franking credits (also referred to as imputation credits), represents the tax that a company has already paid on its profits.

When a company earns a profit, it pays tax. As companies exist to earn profits for their shareholders, companies pay dividends to their shareholders to effectively ‘pay out’ their profits. When paying a dividend to shareholders, if companies didn’t also pass on the tax that they have already paid, the profit would be taxed twice - once by the company and again by the shareholder, and nobody wants that!

In order to avoid this, when a company pays a dividend, the franking credits are also distributed to the shareholders. The taxpayer then reports the dividend and their franking credits in their tax return. The total income received from the company is then included in the shareholder’s tax return.

The great thing about franking credits is that they are refundable to you if you are taxed at a lower tax rate.

In order to claim the franking credits though, the ATO requires that:

• You hold the shares at risk for 45 days. This is referred to as the ‘holding rule’. Holding shares at risk effectively means that you owned the shares for at least 45 days. The 45 day period does not include the date of purchase or the date of sale. Some preference shares need to be held at risk for 90 to be eligible to claim the franking credits.
  

• If you earn under $5,000 of franking credits per year, you don’t have to worry about the holding period rule! As your investments grow though, you might find that you become eligible in the future.

The intent behind this legislation is to stop people buying shares just before the dividends are paid, and then selling straight after.

Share trader vs share investor

When it comes to investing in shares, some people make their money by buying shares for the long-term, and reinvesting the dividends to buy more shares.

Others buy and sell daily to take advantage of price fluctuations that arise in the market.

The ATO has slightly different rules for determining whether you are a share trader (someone that buys and sells regularly) versus a share investor (exercising a long-term buy and hold strategy).

Whether you’re a share trader or a share investor has two fundamental differences from a tax perspective:

• For share investors, any capital losses are quarantined and can only be applied against future capital gains. However, for share investors, losses can be applied against other income if you meet the deferred non-commercial loss rules. Broadly, this will apply if your total income (i.e. share sales) were greater than $20,000 for the year. Whether losses are quarantined or can be used to reduce your other income is an important distinction.
  

• Share investors will receive the 50% discount for holding shares for more than 12 months. However, share traders do not receive this concession, even if they hold the shares for more than 12 months.

The ATO examines a number of criteria to determine whether you are a share trader or a share investor.

• The nature of the activities - i.e. whether you are trying to make money from buying low and selling high
  

• The repetition, volume and regularity of the trading - the more you trade, the more likely you are to be a share trader
  

• Whether you approach share trading like a business
  

• How much money you have invested

Best to seek confirmation from a registered tax agent to be sure!

Utilise your capital losses effectively

We all enter the investment world with grand plans of striking it rich, but the investment world, especially the sharemarket, can be a risky place.

Sometimes, somethings don’t go to plan.

You make a capital loss when the value you sell your shares for is less than what you paid. When you’re classified as a share investor (someone buying shares for the long-term), your capital losses can be offset against capital gains from other asset disposals.

A tip to be careful of here is that you need to apply your losses to your capital gain, before you can receive the 50% discount for shares held for more than one year.

Use your capital losses effectively. If you have made a gain for the year, look at your portfolio and see whether there are any investments with an unrealised capital loss. You may wish to sell these shares to offset your capital gains, and pay less tax overall.

Capital losses can be offset against capital gains in the same year and in future years, so timing is key.

The worst example that sometimes happens is a client realises a large capital gain in one year, and then a major capital loss a few years later. They pay a huge amount of tax in the year of the capital gain, and now have a carried forward capital loss that they never be able to use. That hurts. If they had have been more mindful of timing, they could have saved themselves a hell of a lot of tax.

Time your sales

The profit you make on the sale of investments is added to your other income, and taxed at your marginal tax rate. As the saying goes, the more you earn, the more tax you pay.

When it comes to selling your investments, consider timing your sales to take advantage of upcoming circumstances. Perhaps you are retiring next year and won’t be earning a wage anymore, in this case delaying your share sales until that time could be the difference between paying tax at 47% and paying no tax at all.

Or maybe you are going to take some time off work to raise a family. Delaying the sale until the financial year when you won’t be earning income is a way to make your investment income go even further.

There they are, 9 tips share investors can use to legally pay less tax. A word of warning here, tax is extremely complex, so please treat this article as a high-level overview only. There are plenty of ways you can be caught out when it comes to tax, and it often pays to take advice from an appropriately qualified professional tax advisor here.