John purchased an investment property for $500,000 in 2020 and sells it in 2024 for $700,000. He has claimed $40,000 in depreciation over the ownership period. What is his capital gains calculation before any CGT discount?
Correct Answer
B) $240,000 capital gain
The capital gain calculation is: Sale price ($700,000) minus cost base ($500,000) plus depreciation recapture ($40,000) = $240,000. Depreciation claimed must be added back to the capital gain as it reduces the cost base.
Why This Is the Correct Answer
Option B correctly applies the depreciation recapture principle. The calculation is: Sale price ($700,000) minus cost base ($500,000) equals $200,000, plus depreciation recapture ($40,000) equals $240,000 total capital gain. Under Australian tax law (Income Tax Assessment Act 1997), depreciation claimed on investment properties reduces the cost base, so it must be added back to determine the true capital gain before any CGT discount is applied.
Why the Other Options Are Wrong
Option A: $200,000 capital gain
Option A incorrectly calculates only the basic difference between sale price and purchase price ($700,000 - $500,000 = $200,000) without accounting for depreciation recapture. This fails to recognize that claimed depreciation reduces the cost base and must be added back to the capital gain calculation.
Option C: $160,000 capital gain
Option C appears to subtract the depreciation from the basic capital gain ($200,000 - $40,000 = $160,000), which is incorrect. This misunderstands the depreciation recapture concept - depreciation should be added to, not subtracted from, the capital gain calculation.
Option D: $180,000 capital gain
Option D shows $180,000, which doesn't follow any correct calculation method for this scenario. It neither represents the basic capital gain ($200,000) nor the correct calculation including depreciation recapture ($240,000), suggesting a fundamental misunderstanding of the calculation process.
Deep Analysis of This Finance Taxation Question
This question tests understanding of capital gains tax calculations for investment properties, specifically the treatment of depreciation recapture under Australian tax law. The key principle is that depreciation claimed during ownership reduces the property's cost base for CGT purposes. When the property is sold, this depreciation must be 'recaptured' by adding it back to the capital gain calculation. This ensures taxpayers cannot benefit twice from the same deduction - once as a tax deduction during ownership and again as a reduced capital gain on sale. The calculation involves three components: sale price minus original purchase price, plus any depreciation claimed. This concept is fundamental to investment property taxation and affects cash flow planning, investment decisions, and disposal strategies for property investors.
Background Knowledge for Finance Taxation
Capital gains tax on investment properties involves calculating the difference between sale price and cost base, with adjustments for depreciation claimed. Under the Income Tax Assessment Act 1997, depreciation claimed on buildings and fixtures reduces the property's cost base for CGT purposes. This creates a 'depreciation recapture' effect where the depreciation must be added back to the capital gain calculation. The CGT discount (50% for individuals holding assets over 12 months) is applied after calculating the gross capital gain. This ensures taxpayers cannot double-dip by claiming depreciation deductions during ownership while also reducing their capital gain liability on disposal.
Memory Technique
Remember DRAG: Depreciation Recapture Adds to Gain. Think of depreciation as a weight that 'drags' your cost base down during ownership, but when you sell, you must 'drag' it back up by adding it to your capital gain. The depreciation you claimed was borrowed tax relief that must be repaid through higher capital gains.
When you see a CGT question with depreciation claimed, immediately think 'DRAG' and remember that depreciation adds to the capital gain calculation. Look for the depreciation amount in the question and add it to the basic gain (sale price minus purchase price).
Exam Tip for Finance Taxation
Always check if depreciation has been claimed on investment properties. If yes, add the depreciation amount to the basic capital gain calculation (sale price minus purchase price). Don't subtract depreciation - it always increases the taxable capital gain.
Real World Application in Finance Taxation
Sarah owns a rental property purchased for $600,000. Over five years, she claims $25,000 in building depreciation deductions, reducing her annual taxable income. When she sells for $750,000, her accountant explains that while the basic gain appears to be $150,000, she must add back the $25,000 depreciation claimed, resulting in a $175,000 capital gain. This depreciation recapture ensures she doesn't benefit twice from the same tax advantage and affects her decision about whether to hold the property longer to qualify for the 50% CGT discount.
Common Mistakes to Avoid on Finance Taxation Questions
- •Forgetting to include depreciation recapture in the calculation
- •Subtracting depreciation instead of adding it
- •Applying the CGT discount before calculating the gross capital gain
Related Topics & Key Terms
Key Terms:
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