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Can I use the annual CGT exemption to lower tax at the end of my investment term?

Using your annual capital gain exclusion should be done within the context of your investment horizon and your personal income tax liability.

I am getting married soon and have done some budgeting. My wife and I have decided to put aside a significant amount of money monthly with an investment term of five years, after which we plan to buy a property. 

As part of the investment strategy, a large portion of the investment will be in local equities and Reits [real estate investment trusts]. 

My question is: how do I take advantage of the annual capital gains tax (CGT) exclusion of R40 000 in the context of the three-year rule I have read from Sars? Can I realise a gain of R40 000 even in the first year and declare it as a capital gain or would it be considered income? My intention is not to trade, but to use the CGT annual exemption to lower the tax burden at the end of my five-year investment term.

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Firstly, we would need to clarify when the three-year rule laid down by Sars under Section 9C of the Income Tax Act applies. Section 9C states that as of October 1, 2007, any gain or loss you make on disposal of a qualifying share is deemed to be of a capital nature and would, therefore, give rise to a capital gain or loss.

Where the three-year rule needs to be considered is if the qualifying share has been held for less than three years. The nature of any profit or loss – whether it is a capital gain or revenue – must first be determined using some general capital-versus-revenue tests.

The single most important factor in determining the capital or revenue nature of a profit or loss will be your intention when purchasing the shares.

Establishing your main intention is not always simple as you may have more than one intention with such shares. This would therefore need to be considered on a case-by-case basis. Actions such as the frequency of transactions, method of funding of the purchases and the reasons for selling would be some examples used when determining the intention. If the shares were bought as a long-term asset to yield dividend income, the profit is likely to be of a capital nature. But if you bought the shares to sell at a profit, within the three years, the profit would most likely be of a revenue nature.

However, Section 9C and the three-year rule would only apply if you are buying and selling shares directly, in your personal capacity, on a share trading platform.

As you mention Reits in your question, I am assuming you intend to invest monthly into a combination of unit trust funds rather than direct shares yourself. In this instance, you are simply buying, holding, and selling units within these funds.

The income the asset manager earns from running these funds would be considered revenue in their hands, but any gains made by yourself as the investor will always be taxable as a capital gain. This includes dividends, interest income or a combination of these depending on the underlying holdings of your selected funds.

Therefore, if you are simply moving your unit holdings within a fund to cash and thereafter reinvesting the proceeds back into the funds this is a great technique to ensure you take advantage of the R40 000 annual exemption on capital gains.

By doing this you may yield some of the profits earned within the portfolio without creating a tax liability and rebasing these funds at a higher base cost once you reinvest. Keep in mind that if you have underperforming allocations in your portfolio that you wish to redirect, you can use any capital loss in these funds to offset gains in others, enabling you to increase the volume of units traded on strong performers while simultaneously redirecting poor performers.

Risk

Although this is a very tax-efficient solution that looks simple and elegant on paper, it does come with some unavoidable risks. Disinvesting and reinvesting in unit trust funds takes several working days to conclude. Trying to time the market is not a good investment strategy as markets can be highly volatile. You may be in an unfortunate scenario where you happen to sell at a low point and buy in after a short-term market run, although the opposite could just as easily happen.

Overall, using your annual capital gain exclusion is certainly worth considering but should be held in perspective with your investment horizon, which is only five years, as well as your personal income tax liability.

Often, we fear the burden of capital gains without having calculated what the net tax liability will be on the gain. Remember, capital gains tax can be managed with certain tax methods by using multiple tax years when disinvesting after your investment term.

Lastly, I would suggest you seek professional advice from an independent certified financial planner as I would be cautious using pure equity and Reit allocation for a relatively short, in investment terms, period of five years.

Do you have any questions you would like answered by registered financial planners?

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