Capital gains harvesting is a technique whereby an investor intentionally triggers a capital gains event, of a limited amount, on an investment so as to pay less tax on the same investment in the future. It’s a powerful technique that may result in superior returns on an investment for those who implement it compared to those who don’t.
Realized vs Unrealized Capital Gains
Generally, the only time you’re taxed on an investment is when you sell it and receive cash in exchange. This is referred to as a realized capital gain. Until such time as you trigger a capital gain event by an action such as selling the investment, the capital gains are considered to be unrealized.
There are instances where you may be liable to pay tax on capital gains without selling the investment, but this is beyond the scope of this article. Should you have any questions, please either contact us or check out the SARS website at www.sars.gov.za where you can find plenty of information.
The Annual Capital Gains Exclusion
It may seem counter-intuitive to intentionally realize capital gains so as to reduce future tax, however there is method to the madness. The technique takes advantage of the annual capital gains exclusion provided by SARS, currently set at R40,000. Any realized capital gains for the year beyond R40,000 then gets included in taxable income at the inclusion rate of 40%. This amount, plus any other taxable income for the year, is then tax according to the income tax tables.
For example, if you bought 50,000 shares of company ABC for R10 a share and sold them all a year later for R15 a share, you would have realized capital gains of R250,000 ((R15 – R10) x 50,000). The first R40,000 of this realized capital gain is excluded and then the remainder is included in your taxable income at 40%.
R250,000 – R40,000 = R210,000
R210,000 x 40% = R84,000
Thus, you would include R84,000 in your taxable income for the year. So if you were earning a salary of R400,000 as your only other income you would be taxed on R400,000 + R84,000 = R484,000.
However, if you only sold 8000 shares at the end of the year for R15 a share, you would make R40,000 in capital gains ((R15 – R10) x 8000). This entire amount would be excluded according to current tax laws, and nothing would be included alongside your salary. Thus, you would only be taxed on R400,000.
Note: you do not get an exclusion of R40,000 for each investment you have. The exclusion is applied to all your capital gains in a single year. For example, if you sold an investment property and shares in a company making realized capital gains of R100,000 and R50,000 respectively. The annual exclusion would be applied to the full R150,000.
Weighted Average Base Cost
The example above was very simplistic in the sense that it was just a buy-and-hold scenario with no other shares being bought during the year. In reality however, people often buy different amounts of the same investment at different prices through time. And since capital gains equals the difference between the selling price and the buying price, it becomes necessary to determine the appropriate singular buying price in the presence multiple buying prices. SARS refers to this “buying price” as the base cost of an investment.
For example, instead of buying 50,000 shares at the beginning of the year you could have bought 25,000 shares at R10 a share, and six months later buy another 25,000 at R12 a share. When you sell shares in the future, would the appropriate “buying price” be R10 or R12 per share? The answer is a weighted average of the two, calculated as follows:
(25,000 x R10) + (25,000 x R12) / 50,000
= R250,000 + R300,000 / 50,000
= R550,000 / 50,000
Therefore, if you sold all the shares at the end of the year at R15 a share, you would make realized capital gains of R200,000 ((R15 – R11) x 50,000).
Capital Gains Harvesting in Practice
Since capital gains equals selling price minus the base cost, it follows that a higher the base cost will mean lower capital gains. Capital gains harvesting is the process of selling enough shares (or units of a unit trust) so as to only realize the capital gain amount that’s excluded (currently R40,000) and then immediately repurchasing those same shares or units.
Ideally the price at which the shares are sold and bought should be exactly the same, but higher than the initial price of the shares. This results in an increased base cost for the investment, while the market value remains the same. By increasing the base cost in this way each year, it reduces the tax effect when you finally need to sell a significant amount of the investment.
For example, consider an investor who buys 50,000 shares of company ABC at R10 a share at the beginning of the year. Assuming the share price grows at 10% each year, it would reach R11 a share at the end of the year. The investor would have made an unrealized capital gain of R50,000 ((R11 – R10) x 50,000).
The investor would then need to sell 40,000 shares at R11 a share to make a realized capital gain of R40,000. Then repurchase these same shares at R11 a share. This would bring the base cost of the investment up from R10 a share to R10.80 a share. The money flow is as follows:
Assuming the investment grew at 10% per year, and the investor applied the capital gains harvesting technique each year, to finally sell the full investment after 10 years. The investment schedule would be as follows:
Assuming the capital gain amount was the investor’s only taxable income for the year, the tax on a full withdrawal after 10 years of growth while utilizing the capital gains harvesting technique will be:
If the investor did not use the technique and simply bought the 50,000 shares at R10 a share and sold them after 10 years at R25.94 a share, the realized capital gains would be R797,000 ((R25.94 – R10) x 50,000). The tax on this realized capital gain would be:
As you can see, the investor who employed the capital gains harvesting technique paid R47,796 less tax than the investor who did not use the technique.
Things to Note
Firstly, the comparison above was done assuming the tax tables did not change over the 10 years, which is incredibly unlikely. Secondly, when harvesting the capital gains it’s very unlikely that you’d be able to sell and repurchase at the exact same price. This is due to money taking time to move through the financial system. However, the price movement is generally negligible but be aware that the money flow is not instantaneous. Despite these things, the technique still results in paying less tax over the long-term.