Can I offset capital losses?
What status means for your income
So you think of yourself as a share trader: you buy and sell shares frequently. But do you do this is out of work hours, or for work?
Defining which of these alternatives describes you is more than just a matter of justifying to your family how much time you spend on the computer. If you actually buy and sell shares as a self-employed professional, the Australian Taxation Office (ATO) will treat you differently to ordinary share traders.
Provided the non-commercial losses rules are satisfied, the ATO allows professional traders to treat profits made from share trading as ordinary income, not capital gain; and to claim an immediate deduction for their trading losses and offset the losses against other taxable income, such as salary and wages, interest and dividends.
Professionals may be able to claim expenses, such as brokerage, as a tax deduction. Being in the business of trading shares for gain, they are allowed to use all the provisions relating to business, one of which is their shares are treated as trading stock, and any profits made are on the revenue account.
For traders, gains are not actually “capital” gains because the trader is not assessed under the capital gains tax (CGT) regime: any change booked in the value of a trader’s stock is either assessable as income or deductible as a loss. Unrealised losses may be claimed in a tax year, but gains don’t have to be brought to account until realised.
For all other shareholders, capital gains incur CGT and the only losses that can be claimed are realised capital losses, which can be offset only against realised capital gains, in the same year or future years.
Net sale value is minus brokerage paid. The cost of buying shares is not an allowable deduction, and profit from sales is not assessable income. The catch is: you cannot declare yourself a trader. Your level of activity dictates whether the ATO treats you as such. If you meet certain criteria set by the tax law and the ATO’s guidance, you may be classified as a professional trader.
Adrian Raftery, senior lecturer in financial planning and superannuation at Deakin University, says taxpayers often try to class themselves as traders in financial years when investments plummet. “The ATO doesn’t like it when people try to declare themselves a trader depending on how the stock market is going at the time,” he says.
If you have claimed a CGT discount in previous returns but now – realising losses – want to be able to claim an immediate deduction on the revenue account, the ATO will notice.
The introduction in 1999 of the 50 per cent CGT discount took away much of the perceived advantage of professional-trader status.
When a trader sells shares, the profit is liable for income tax at up to 46.5 per cent, whereas for an ordinary investor on the top marginal tax rate, if the shares have been held for longer that 12 months, only half of the capital gain incurs CGT, meaning that the investor pays CGT effectively at a maximum rate of 23.25 per cent.
If you class yourself as a trader, says Raftery, the ATO may ask you to provide evidence to prove you are carrying on a trading business. This might include evidence of:
• buying and selling on a regular basis (the higher the volume of transactions, the more likely you are carrying on a business);
• the use of any trading techniques;
• decisions based on thorough analysis of relevant market information;
• a contingency plan in the event of a major market shift; and
• a trading plan showing analysis and research of each potential investment, the market and any formula for deciding when to hold or sell investments.
Even if you can show that you are carrying on a business of share trading, you will need to satisfy the non-commercial loss rules in order to offset share trading losses against other income. Broadly, under the non-commercial loss rules, you can only offset a share trading loss against other income if your adjusted taxable income is less than $250,000 for the year (excluding the share trading loss) and you satisfy one of the following four tests:
• Assessable income generated by the business is at least $20,000 (assessable income test);
• The business shows a profit for at least three out of the last five years (profits test);
• The business has property or an interest in real property with at least $500,000 on a continuing basis (real property test); or
• The business has at least $100,000 of other assets being used on a continuing basis (other assets test).
The only other way the ATO will allow you to offset your trading loss against assessable income from other sources is if the Commissioner of Taxation uses his discretion to allow you to claim the loss. This rarely happens.
“Assuming that you have satisfied those rules, you can qualify for claiming any trading loss in your tax return. If you have earned less than $10,000 in other income to offset these losses, show your taxable income as zero. The remainder of the unutilised losses are carried forward and can be offset against income in future years,” says Raftery.
If an ATO audit finds you have incorrectly claimed trading losses and you cannot satisfactorily show you are carrying on an investment business, your deduction will be disallowed and penalties might apply, says Raftery.
Moreover, if you change from being an investor to a trader (or vice versa), the ATO may request evidence to prove the change is correct, and that you have not declared your income incorrectly in previous tax returns.
Importantly, a self-managed super fund (SMSF) cannot be considered as trading entities: it needs to carry out share activities as an investor. And investing in shares must accord with the fund’s written investment strategy, and comply with the SIS Act that regulates SMSFs.