Capital gains and inflation adjustment

[Monid]

Hi Guys

I've said both here and elsewhere that before you count your capital gains you need to inflation adjust them.

This is important because the money you paid at time X for a property is now worth (due to inflation) more at time Y.

This means you get less profit than you expect when you sell a property in a few years time, because the money you spent on it is worth more in real terms than the nominal value that you paided at the time.

The question is how do you work this out if you are trying to decide to sell a property?

Do you take present price, subtract old price then subtract holding costs, taxes & selling costs call that the profit then inflation adjust that amount?

Or do you take present price, inflation adjust old price and subtract this from present price then subtract holding costs, taxes & selling costs and call that amount the profit?

Both methods give you different amounts, but which one is a better representation of what really goes on?

Or if that was too confusing let me know and I will try to provide an example.

Cheers
David

[SuperDad]

Nothing like a bit of mental gymnastics first thing in the morning.

How would I inflation-adjust when calculating profit on exit?

Do you take present price, subtract old price then subtract holding costs, taxes & selling costs call that the profit then inflation adjust that amount?

Or do you take present price, inflation adjust old price and subtract this from present price then subtract holding costs, taxes & selling costs and call that amount the profit?

I would use the latter method. Inflation adjusting the old price reflects what effect inflation alone has had on the asset value.

Take as an example a house that is worth $200K at Year One. Assuming 7% growth, the property is worth $393,430 in Year Ten. Assuming 3% annual CPI inflation, in Year Ten it would take $268,783 to purchase what $200,000 would purchase in Year One. So the gross profit from sale, inflation adjusted, would be $124,647 ($393,430 minus $268,783). As one is selling in Year Ten, one would then take the selling costs in Year Ten dollars off this inflation-adjusted gross profit to yield the net profit.

Paul.

[keleri]

Is it really necessary to know in depth what profit you have made? If you are thinking of selling there should be a valid reason. The question therefore is 'Can I make better use of my money by selling or should I hold'. Its better to know the value now and what you can do with it than what it was worth 10 years ago

[Monid]

Thanks Paul, thats what I am leaning towards as well but mental gymnastics were being to stretch me...

Keleri its a good question, but it depends on what strategy you are adopting. You are right if you are doing a simple long term buy and hold then knowing precisely how much money you have made if you sell and then buy into another asset is fairly irrelevant. (Though personally I'd still like to know it.)

But there are many people who don't invest in property for the long term cashflow, many buy negatively and hope for a capital gain, others myself included might view ourselves as long term investors but occasionally be tempted to the dark side of disposing our assets because it simply sounds like we are going to make more money by doing that, than by holding on to them. In these cases knowing precisely how much you will make or lose by selling becomes all important, because it underwrites the decision.

So sometimes, yes it would be irrelevant, other times no it would be make or break for the chosen strategy.

David

[Rolf]

To get a truly inflation adjusted figure you would need to add compound inflation adjusted rental income for the period the property is hold.
And similarly subtract the compound adjusted expenses.

[Re@der]

Most businesses would judge an investment opportunity based on the other opportunities they had with those funds. These other opportunities are known as the opportunity costs. Any investment must produce more than the opportunity cost. Where inflation fits this I am not sure. In post evaluation of was this a good investment one could look at the current value versus the current value of your other opportunity. If in the positive this was a good investment.

[Gerrard]

Hey David - personally I went down the easy route. If I sell this property for $X today, how much money will I end up with in my pocket and what will I do with that money.

That combined with finally understanding the priorities in my life led to a sell now decision.

There's some old business logic that says ignore sunk costs and calculate only form this day on. Of course looking forward I've come up with lots of scenarios but who know's how it's really going to turn out. Today ende dup being far more important to me.

Gerrard