The tax implications of realising capital gains and losses in a self-managed superannuation fund (SMSF or Fund) have traditionally been in the realm of what accountants consider at year end. However, changes to the exempt current pension income (ECPI) rules which applied from the 2017-18 financial year and going forward mean it is now important for SMSF retirees to plan in advance and be strategic around the sale of assets (and more specifically the capital gains tax consequences) where an SMSF is moving into the retirement phase.
A strategic wrong turn can mean additional compliance costs and poor tax outcomes. The new ECPI rules provide an opportunity for advice to improve client outcomes.
Taxation of capital gains and losses
The net capital gains of an SMSF for an income year form part of the Fund’s assessable income.
How capital gains or losses are taxed will depend on whether any of the Fund members are in retirement phase, and the method the Fund must use to claim ECPI.
For an SMSF with no retirement phase interests (i.e. only accumulation or non-retirement phase transition to retirement income stream (TRIS) accounts), all net capital gains will be taxable and capital losses can be carried forwards.
Where an SMSF has retirement phase interests we must first determine whether the Fund will use the proportionate method, the segregated method or both when claiming ECPI to understand the taxation of any capital gains and losses.
SMSFs solely in retirement phase for the entire income year (account-based pensions, TRIS in retirement phase, market linked pensions) will disregard capital gains and losses. This means that capital gains are fully tax exempt and capital losses carried forward from previous years do not need to be offset against capital gains realised in the current year.
However, where an SMSF has both non-retirement phase and retirement phase accounts in the income year, the taxation of capital gains will depend on the retirement phase status of the Fund at the time of sale. If the Fund had a non-retirement phase account at all times in the income year, or had disregarded small fund assets, then the actuarial exempt income proportion will apply to the net capital gain over the whole income year. If the Fund had net capital losses, then those can be carried forward.
If the Fund did not have disregarded small fund assets and had periods of the year where assets were solely supporting retirement phase accounts, then:
- A net capital gain realised during any period where the Fund had a non-retirement phase interest would have the actuarial exempt income proportion apply, and a net capital loss could be carried forward.
- Capital gains or losses realised when the Fund was solely in retirement phase must use the segregated method and are disregarded.
Under the ECPI rules, the timing of when capital gains and losses are realised becomes a very important consideration in the advice process when looking to sell assets as SMSF members move into retirement.
Case study: Business real property sale when a member retires
Sam, aged 64, and his wife Catherine, aged 63, have been saving for retirement using an SMSF and have no other superannuation accounts.
At 1 July 2018 all balances were in the accumulation phase and tables one and two show the assets and interests that were in the SMSF.
The SMSF is expected to receive income in 2018-19 of around $53,000 which will have been earned approximately uniformly over the year except for managed fund distributions of approximately $6,000 that will be paid on 30 June.
Sam has operated his HR business out of consulting rooms owned by his SMSF and has done so for many years. He is planning to wind up his business in May 2019 and retire. He was thinking he would commence an account-based pension on 1 July 2019.
Catherine receives taxable income from their family trust investments of around $50,000 per annum. She had been working part-time at university in an admin role but retired effective from 31 December 2018. She commenced an account-based pension with her entire balance at 1 January 2019.
Sam and Catherine do not wish to retain the business premises in the SMSF as it will require some significant updates to optimise the rental income. Retention of the property may also lead to liquidity issues in the SMSF down the track. They have received some offers on the premises and are likely to sell the property this financial year.
Sam and Catherine have come to you for advice… “Does the timing of when Sam retires and the business real property owned by the SMSF is sold effect the tax payable on any capital gain?”
To answer this question, we need to understand how capital gains would be taxed in the SMSF if realised as expected in the 2018-19 financial year.
Selling the property in the 2018-19 financial year
In 2018-19 Sam and Catherine’s SMSF may be expected to have the liabilities shown in chart one over the year:
Chart 1: Sam and Cathy’s SMSF’s liabilities for 2019
A key takeaway from chart one is that in the 2018-19 year the SMSF always has a non-retirement phase account.
In green, we see Catherine and Sam’s accumulation interest in the first half of the year, and Sam’s accumulation interest in the second half of the year. They grey section represents Catherine’s account-based pension which commenced 1 January 2019.
The SMSF will use the proportionate method to claim ECPI in the 2018-19 financial year and the actuarial exempt income proportion would apply to any capital gain(s).
If the transactions played out as described above and the $400,000 capital gain was realised prior to the end of the 2018-19 financial year, the actuary would certify an exempt income proportion of just over 13 per cent. This would mean that 13 per cent of the net capital gain would qualify as exempt current pension income, and 87 per cent of the gain would be taxed.
To increase the amount of exempt income on a capital gain incurred in this scenario for the 2018-19 financial year, we need to take actions in order to affect an increase in the actuarial exempt income proportion.
Improving tax exempt capital gains
We know that Sam is looking to retire and commence an account-based pension in the SMSF. He turns 65 on 14 May 2019, at this time he will be eligible to commence an account-based pension in the SMSF even if he has not fully retired at that time.
Thinking strategically, we also know that another income stream in the SMSF for part of the year could be expected to increase the value of the retirement phase liabilities and in turn increase the actuarial exempt income proportion.
We decide to examine the impact on the tax outcome if we recommended that Sam commence his pension on 14 May 2019 with his entire balance instead of on 1 July 2019.
In 2018-19 Sam and Catherine’s SMSF may be expected to have the member liabilities shown in chart two over the year if Sam commenced an account-based pension on 14 May 2019.
Chart 2: SMSF liabilities for 2019 had Sam commenced an account-based pension
We see in chart two that the SMSF would now have a period where the Fund is solely in retirement phase from 14 May to 30 June 2019 after Sam commenced his pension.
To determine the taxation of a capital gain we need to identify whether the SMSF has disregarded small fund assets in 2018-19.
Looking back at Catherine and Sam’s total superannuation balance at 30 June 2018 we see that neither member had a retirement phase account and total superannuation balance in excess of $1.6million. The SMSF will therefore not have disregarded small fund assets in the 2018-19 financial year. This means the SMSF will be deemed to have segregated pension assets where those assets are solely supporting retirement phase liabilities.
The SMSF will use both of the methods outlined above to claim ECPI on Fund income in the 2018-19 financial year as follows:
- Proportionate method from 1 July to 13 May; then
- Segregated method from 14 May to 30 June.
The Fund actuary will exclude the retirement phase segregated assets from their calculation which results in an exempt income proportion of just over 11 per cent which will in turn apply to all Fund income and any net capital gains incurred from 1 July to 13 May.
Income incurred in the period that the segregated method is used will therefore be 100 per cent exempt and capital gains will be disregarded for tax purposes.
Chart two outlines that the timing of when a capital gain is incurred in this Fund will be critical in terms of the taxation of the $400,000 capital gain. If the property is sold prior to 14 May 2019, 11 per cent of the capital gain will be exempt, but if it is sold on or after 14 May 2019, the capital gain will be 100 per cent exempt. This could result in a significant difference in the tax payable based on the timing of when the capital gain is realised.
Where Catherine and Sam have an offer to sell the property in the 2018-19 financial year, you might recommend that (to maximise the exemption on the capital gain), a retirement phase income stream is commenced for Sam prior to selling the property with his entire balance. This will create a period of deemed segregation and the capital gain will be tax free.
How would disregarded small fund assets change the tax outcome?
If a Fund has disregarded small fund assets then that Fund must use the proportionate method to claim ECPI. This means that even if the Fund had a period where assets were solely supporting accounts in retirement phase, the Fund would use the proportionate method to claim ECPI.
If we re-consider the case study above and assume that Catherine was also in receipt of an account-based pension in a retail superannuation fund with a balance of $550,000 at 30 June 2018, the SMSF would then have disregarded small fund assets in the 2018-19 financial year. This is because at 30 June 2018 Catherine had a total superannuation balance in excess of $1.6million and a retirement phase account.
Irrespective of when the $400,000 capital gain was realised in 2018-19, the SMSF must use the proportionate method to claim ECPI and the tax exemption on the capital gain would be based on the actuarial exempt income proportion.
If we again assume that Catherine had commenced a pension on 1 January 2019 and Sam commenced a pension on 14 May 2019 then in this case the actuary would not exclude the period where assets were solely supporting retirement phase interests from 14 May to 30 June. The exempt income proportion applying to all income including the $400,000 capital gain would be just over 22 per cent.
This is an improvement over the original 11 per cent in the initial part of the case study but not nearly as good as the 100 per cent exemption obtained by realising the capital gain in a deemed segregated period. Unfortunately in this scenario, the SMSF would have no choice. Where an SMSF has disregarded small fund assets, the proportionate method must be used.
In this scenario, in order to improve the tax outcome on the capital gain you might recommend that Sam and Catherine defer the sale of the property until the 2019-20 financial year.
In 2019-20 Sam and Catherine’s SMSF may be expected to have the liabilities shown in chart three.
Chart 3: Sam and Catherine’s SMSF’s liabilities for 2020
At 1 July 2019 we see that the SMSF is solely supporting retirement phase accounts. Both Catherine and Sam have their entire balance in account-based pensions. The Fund’s income will be 100 per cent exempt and capital gains and losses disregarded.
By deferring the capital gain to 2019-20 the $400,000 will be entirely exempt compared to 22 per cent exempt if realised as shown previously in 2018-19.
Note that because Catherine continues to have a total super balance above $1.6 million the Fund continues to have disregarded small fund assets in 2019-20. This means the Fund has to use the proportionate method to claim ECPI and an actuarial certificate would be required to claim other income as exempt current pension income on the annual return.
The Morrison Government’s Budget on 2 April 2019 proposed a change to the ECPI rules to remove this requirement for an actuarial certificate. Under the proposal an SMSF in this situation would not require an actuarial certificate to claim income as exempt current pension income in its annual return.
What would change if the asset being sold would realise a capital loss?
Capital losses realised when an SMSF is solely in retirement phase are disregarded for taxation purposes and cannot be carried forward to offset future capital gains. Where an SMSF asset is being sold at a capital loss it may be beneficial to consider strategies that allow for that loss to be carried forward.
This is relevant for SMSFs which may realise taxable capital gains in the near future, and also those Funds which are currently solely in retirement phase. For example, if one person in a couple passes away with large balances, the spouse may commute some of their pension to accumulation in order to receive a death benefit income stream. In this scenario, any capital gains incurred in the SMSF would go from 100 per cent exempt to only partly exempt, and the Fund would benefit from having capital losses carried forward to offset those gains.
Let’s consider the scenario above where Catherine and Sam sold their property in the 2019-20 year when the Fund was solely in retirement phase. If the property was sold for a capital loss that loss would be disregarded for tax purposes.
If Catherine or Sam made a contribution to the SMSF of say $10 at 1 July 2019 then the Fund would no longer be solely in retirement phase.
Chart 4: SMSF’s liabilities for 2020 had Catherine or Sam made a $10 contribution
We see an illustration of the Fund liabilities in chart four. The green section shows the accumulation balance over the 2019-20 financial year and the Fund would therefore be required to use the proportionate method to claim ECPI. The capital loss realised could be carried forward, and the ECPI claimed on other Fund income would have the actuarial exempt income proportion apply.
In this case the Fund actuary would certify 99.9 per cent of the Fund income is exempt. The Fund would be able to carry forward the capital loss without materially impacting their tax exemption on other Fund income.
It is important to understand ECPI and disregarded small fund assets when making investment decisions about selling Fund assets. In order to better manage the tax outcomes a trustee and their advisers should aim to be strategic and make plans in advance of assets being sold.
Melanie Dunn is the SMSF technical services manager and an actuary at Accurium.