You might have heard the terms ‘income return’ and ‘capital return.’ These are the two different ways to make money on an investment.
Income return is the return you receive while you continue to hold an investment. In the sharemarket, the income return comes as dividends. In the property market, the income return comes as rent. If you have a term deposit or make a loan to somebody, the income return is the interest you receive on that investment.
Capital return is the return you receive when eventually you dispose of your investment asset. Usually, this means selling the asset. If the amount you receive when you sell the asset is greater than the amount you paid for it, you have made a capital gain. Alternatively, if the value of the asset has fallen while you hold it, you have made a capital loss.
Different investment assets offer different blends of income and capital return. Traditionally, residential property has offered a relatively low level of income return and a relatively high level of capital return. The sharemarket has a more balanced mix between dividends and capital gains. Cash type investments such as term deposits do not provide any capital growth at all – at the end of the investment period, you simply receive back the same amount that you invested in the first place. The only return is the interest that you receive during the period of the investment. This is all income return.
Different investors often prefer different blends of investment return. Often, this is because of the different ways in which income and capital return is typically taxed. Income return is generally taxed in the year in which the income is received. So, if you receive rent on an investment property, you pay tax on that rent in the year that you receive it. Income return is generally added to any other taxable income you may have in that year, such as wages or salary, and taxed at your marginal tax rate for that year. Marginal tax rates are ‘progressive,’ which means that the tax rate increases when your income goes above certain thresholds.
In contrast, capital gains are generally taxed only when the asset is sold. Generally, any capital gain is added to your other taxable income from the financial year in which you make the sale and taxed at your marginal tax rate. So, tax on capital gains is paid in the year in which the asset is sold.
That said, capital gains often also attract a discount when it comes to taxation. If you hold an asset for more than 12 months, 50% of the capital gain is exempt from capital gains tax (CGT). This is provided that the investment is held either in your own name or via a trust. Companies do not receive the 50% CGT exemption.
This frequently means that capital gains are preferentially taxed. $1 of capital gain is often subject to less tax than $1 of income return. As a result, people with high marginal tax rates often prefer to receive their investment return more in the form of capital return than an income return. A given level of capital return will incur less tax on the same level of income return.
The problem with a capital return, of course, is that you cannot spend money that remains stored in an investment asset. That is why people such as self-funded retirees often prefer investments with a greater proportion of income return – the income that they receive partly or completely finances their lifestyle. They need that income to spend.
When you stop to think about it, all personal taxation can be looked at as a ‘potential for consumption’ tax. While an investment return remains locked in an asset that has appreciated in value, that return cannot be consumed. However, once the asset has been sold and converted to cash, the capital return can be consumed – and this is the point at which the tax office imposes its taxation.
So, investors who want to minimise tax do well to hold their wealth in forms other than cash.
Your preferred blend of income and capital return depends on your personal circumstances. We urge you to contact us to discuss which of income return and capital return your own investment portfolio should be targeting.
The tax component of the above analysis was prepared by Rolando Chou, a registered tax (financial) adviser.