What it means
Businesses and individuals hold assets for two kinds of return: the income they produce while held (rent, dividends, interest, use in the business) and the change in their value over time. A capital gain is the second kind, crystallised at the point of disposal.
Until then, an asset that has risen in value carries an unrealised gain, which may be shown in the accounts through revaluation but is not usually taxed. In company accounts, the gain on disposal of a fixed asset is the difference between the proceeds and the carrying amount (cost less accumulated depreciation and impairment).
Because depreciation has already reduced the carrying amount, an asset sold for more than its written-down value shows a gain even if it is sold for less than it originally cost; the gain is really a correction of over-depreciation. Gains on disposal are shown separately from operating revenue, because they are not part of the recurring business and readers of the accounts need to see the underlying trading result without them.
For tax, most jurisdictions have a capital gains regime. The taxable gain is computed from proceeds less an allowable cost base, which may be adjusted for inflation (indexation) or for the period held.
Rates are often lower than income tax rates, particularly for long-held assets, on the argument that part of the gain is inflation and that lower rates encourage investment; some countries exempt gains on a main residence, on small business assets, or on assets held for very long periods, and some do not tax capital gains at all. Losses on the disposal of capital assets are usually deductible only against capital gains, not against income, and unused losses are carried forward.
The interaction between the accounting and tax figures is a routine source of adjustment. The accounting gain uses the carrying amount; the tax gain uses the tax base, which may differ because tax depreciation followed a different schedule or because indexation applies.
Deferred tax is recognised on the difference between an asset's carrying amount and its tax base, so that the tax that will eventually be paid on a disposal is reflected in the accounts as the value builds. Managing capital gains is part of financial planning.
Timing a disposal into a year with capital losses to offset, or into a tax year with a lower rate, or after a holding-period threshold has been passed, can change the after-tax proceeds materially. Reinvestment reliefs in some jurisdictions defer the gain if the proceeds are reinvested in qualifying assets.
The general principle is that a gain should be calculated before the decision to sell, not discovered after it.
In practice
Real-world examples.
Example
An investor sells shares bought for $20,000 for $35,000 and pays capital gains tax on the $15,000 gain after an annual exemption.
Example
A company sells a fully depreciated machine with a carrying amount of nil for $8,000 and reports an $8,000 gain on disposal.
Example
A founder sells her business for $4,000,000 against a cost base of $100,000 and claims a reduced rate available for business assets held over five years.
Think of it
“Capital gains are profits from selling investments-the difference between what you paid and what you got.
Formula
Calculation
Capital Gain = Disposal proceeds minus Cost base
Cost base = Purchase price + Acquisition costs + Improvement costs minus Capital allowances claimed (where applicable)
Accounting gain on disposal = Proceeds minus Carrying amount
Worked example. A company bought a warehouse eight years ago for $1,200,000, paying $40,000 in legal fees and transfer taxes, and spent $160,000 on a permanent extension three years later. It has depreciated the building (excluding land) at $25,000 a year, so accumulated depreciation is $200,000 and the carrying amount is $1,200,000 + $40,000 + $160,000 minus $200,000 = $1,200,000. It now sells the warehouse for $1,850,000, paying $30,000 in agent's and legal fees.
Accounting gain on disposal = ($1,850,000 minus $30,000) minus $1,200,000 = $620,000, shown separately from operating profit.
Tax computation (illustrative regime: indexation not available, disposal costs deductible, building allowances of $150,000 claimed reduce the cost base):
- Net proceeds = $1,820,000
- Cost base = $1,200,000 + $40,000 + $160,000 minus $150,000 = $1,250,000
- Taxable gain = $570,000
- The company has $80,000 of unused capital losses from an earlier share disposal, reducing the gain to $490,000
- Capital gains tax at 20% = $98,000
The accounting gain ($620,000) and taxable gain ($570,000) differ by $50,000 because the tax allowances claimed ($150,000) were less than the accounting depreciation ($200,000). Deferred tax had already been recognised on that difference, so the total tax charge in the accounts reconciles.
Timing point: had the company sold in the previous year, when the rate was 25%, the tax would have been $122,500. Had it waited to use a further $60,000 of losses expected next year, the tax would fall by $12,000 but the buyer might have walked away. The decision is made on the whole picture, not the tax alone.Case study
Seen in the real world.
A family company had held a plot of land next to its factory for thirty years, bought for $60,000 and now worth $2,500,000 following a change in planning rules. The directors received an offer and were ready to accept when the finance director asked for a tax computation. The gain was $2,440,000; tax at 20% would be $488,000.
He identified three things worth examining before signing. First, the company had $210,000 of capital losses from a failed investment that would offset part of the gain. Second, a reinvestment relief allowed the gain to be deferred if the proceeds were used within three years to buy qualifying business assets, and the company was planning a $3,000,000 factory expansion.
Third, the land could be sold in two tranches across two tax years, which would use two annual exemptions and smooth the cash tax. The directors chose to sell in one tranche, claim the losses, and roll the balance of the gain into the expansion, deferring $446,000 of tax indefinitely. The finance director's note observed that the tax had not changed the decision to sell, but that a week's work had changed the after-tax proceeds by nearly half a million dollars, and that the same analysis should precede every significant disposal.
Watch out
Common mistakes.
- Confusing the accounting gain (proceeds less carrying amount) with the taxable gain (proceeds less tax cost base). They usually differ.
- Forgetting to include acquisition and disposal costs and improvement expenditure in the cost base, which overstates the gain.
- Selling without checking available losses, reliefs, exemptions and timing, which can change the tax substantially.
Questions
People also ask.
Are capital gains taxed as income?
In most systems, no: they have their own rates and rules, often more favourable for long-held assets. Some countries tax them as income and some not at all.
Is a gain taxed if the asset is not sold?
Generally not. Tax usually applies on realisation, although some assets (traded securities in some regimes) are taxed on a mark-to-market basis.
Can capital losses offset ordinary income?
Usually only in limited amounts or not at all. They offset capital gains and are carried forward.
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