SMSF trustees invest with the goal that fund assets increase in value and when sold, they make a profit. Unfortunately, it is not always the outcome and sometimes assets are sold at a loss. However, where an asset is to be sold and a loss will be the expected outcome, it is worthwhile to understand how to utilise the loss to benefit the fund as much as possible.
When an SMSF asset is sold during the year, and the fund uses the proportionate method to claim exempt current pension income (ECPI), the timing of the sale will not have an impact on the tax calculation. The exempt income proportion from the actuarial certificate will apply to all unsegregated fund income earned during the income year, including any capital gains, no matter when they occurred. Capital loses, both current year and brought forward, will be offset against capital gains, prior to applying the one third CGT discount and before applying the exempt income proportion. Where, after offsetting capital losses, a net capital loss remains, it will be carried forward to the next income year, in full – the exempt income proportion will not be applied to any net capital loss that is carried forward to subsequent income year.
However, for funds which have the option of selling assets in different income years or have segregated assets, the timing of when a capital loss arises does need to be considered.
Matching Capital Gains
As noted above, capital losses, either current or carried forward, must first be applied to offset capital gains. This can result in loses being effectively wasted by being applied against capital gains in a year when the fund tax exemption proportion was high and consequently the tax on the capital gain(s) in isolation, would have been relatively small. For a fund which can control when it realises a capital loss, it would be a worthwhile exercise to try to predict which years will have a lower tax exemption proportion, so that capital loses are better utilised.
While this could have a large impact for funds which have large capital gains and/or a significant variation in the tax exemption proportion between different income years, it does require you to predict the exempt income proportion for multiple years and have the ability to retain assets in the fund for an extended period. This ability to accurately predict so far ahead and retain assets for multiple years is likely be difficult for most funds.
The ability to predict the future, where fund assets may be sold at a loss, is not so important when the SMSF has segregated assets.
A fund will have segregation if an asset, or assets, are specifically allocated to solely support a retirement phase income stream. Traditionally, this required a specific election in writing to implement the segregation for an asset but from 1 July 2017 it has become more complicated.
With the new superannuation measures introduced from 1 July 2017 the ATO also clarified their view on asset segregation. Essentially, it was confirmed that if a fund is entirely in retirement phase for any period it will be deemed to be segregated, provided the fund did not have any ‘disregarded small fund assets’ for the year of income. This means that an SMSF can have a period of segregation in a year, without the SMSF trustee(s) specifically choosing to do so.
Being aware of asset segregation is important as capital gains and capital loses which are made on a segregated asset are disregarded. This is a positive, from a tax perspective, for capital gains, as no tax will be paid on the gain. However, it’s not a good outcome for capital loses, as they will be disregarded and can’t be used to reduce any unsegregated capital gains, that is, capital gains that arise in a period that the fund will use the proportionate method to claim ECPI. With this in mind, from a tax perspective, SMSF trustees should consider disposing of an asset, which will realise a capital loss, during a period where the proportionate method to claim ECPI will apply. This is not as easy as it used to be due to the possibility of deemed segregation.
Adam and Julia are both members of the Retire Right SMSF. As at 1 July 2020 neither of them had met a condition of release and as such their balances were entirely in accumulation phase. On 16 October 2020 Julia turned 65 and her balance became unrestricted non-preserved, so she decided to commence a retirement phase income stream (an account-based pension) with her entire accumulation balance. Adam will turn 65 on 13 March 2021 and it is currently his intention to also start a retirement phase income stream (an account-based pension) for his entire balance at that date.
The fund has a property which it is intending to sell that is currently in a loss position. Adam and Julia are now considering when would be the most advantageous time to sell the asset. If it is sold during the 2020/21 income year they understand that the tax treatment of the loss will depend on when the asset is actually sold. If sold between 1 July 2020 and 12 March 2021 the sale will be during a period that the proportionate method will be used to claim ECPI. Consequently, the capital loss will either reduce capital gains or be carried forward. However, if sold from 13 March 2021 onward, the sale will be during a period of deemed segregation and consequently the CGT event will be disregarded – the capital loss will be lost.
Another possibility is to retain the asset so that it can be sold in a future income year, but unless the fund has a member with a non-retirement phase interest, e.g. an accumulation balance, the CGT event and the resulting capital loss would still arise in a deemed segregation period and be disregarded. Even if the fund does have members with an accumulation balance at some point, Adam and Julia expect the balance to be very low, comparative to their account-based pensions. As the accumulation balance would be relatively low, this would cause the fund to remain predominately tax exempt, that is, the fund’s ECPI percentage would be close to 100%. This would significantly reduce the tax which would be payable on any capital gains and consequently reduce the effectiveness of realised capital losses.
After considering the situation, Adam and Julia decide to sell the asset before 13 March 2021 to ensure the loss can be used in the current year, is not disregarded and that the SMSF maximises the tax benefit from the capital loss.
As this article has discussed, depending on the SMSF’s circumstances, it can be very easy for a fund to underutilise capital loses. Further, since 1 July 2017 with the application of the concept of periods of deemed segregations, capital losses arising from the sale of fund assets can be disregarded and lost, forever. While it can be challenging, this illustrates the importance of planning when it comes to realising capital loses to ensure they can be best utilised against current year or future capital gains. Depending on the amount of capital gains and the proportion of fund tax exemption, such planning can have a significant impact on the SMSF’s overall tax outcome.