When investing in a rental property, it is essential to realise that tax isn’t the most important factor. The most important factor is to buy a house that will increase in value as much as possible. This sounds obvious, but it is surprising how many people invest in rental properties with the main aim of “getting a tax break”.
However, understanding how tax affects rental properties cab often increase your overall return on investment (“ROI”).
Capital Gains Tax (“CGT”)
The most important way tax affects rental properties is in regard to Capital Gains Tax (“CGT”). CGT is not a separate tax besides income tax – CGT is actually income tax on capital gains. Essentially, a capital gain occurs when you buy an asset and sell it for more than you bought it. The capital gain is the excess in sale proceeds after deducting the cost of the asset. The capital gain is added on to any other income earned and taxed at the relevant income tax rate.
The most important thing to keep in mind about CGT is the 50% CGT discount concession. This concession halves the capital gain on a rental property (and most assets for that matter) if you have held the property longer than 12 months. This can halve the tax you pay! It is a huge concession by the government and shouldn’t be taken for granted, as the government may decide to stop the concession in future (not likely in the near future though).
As an overall wealth building strategy, it is therefore much more tax effective to receive income in the form of capital gains, rather than wage/salary income, as the tax rate can be halved. Given our current very high individual tax rates in Australia, this strategy alone can significantly increase wealth.
Annual income and expenses
Besides CGT, the next thing to keep in mind from a tax perspective is to firstly make sure income and expenses are recorded on your tax return correctly, then to maximise annual tax deductions claimed.
Recording income is simple. You just add up the income received for the financial year. If you use a real estate property manager (which most people do), they provide an annual statement with total income received.
Recording expenses is more involved. The most common expenses are interest on mortgage, council rates, water rates, insurance, and repairs and maintenance (“R&M”). A real estate property manager will usually keep track of some outgoings, depending on the agreement you have with them.
Depreciation is an expense that is not actually an outgoing, yet a deduction is claimed. Depreciation is essentially a way of deducting the cost of depreciable assets over time. Broadly, assets are usually classed as items that last longer than twelve months (not all assets are depreciable, however). The concept is that because the asset isn’t “used up” within a financial year, a deduction for the cost of the asset should be apportioned over time based on the effective life of the asset.
The main depreciable asset for a rental property is the cost of constructing the building. The cost is depreciated at 2.5% per annum. Only the actual construction cost can be depreciated – not the land value or market value of the property.
Some items within a rental property can be depreciated at higher rates e.g. dishwasher, oven, air conditioning unit, carpet, light fittings, TV, couch. The rate depends on the effective life of the asset. The ATO publishes on its website a comprehensive list of the effective lives of many rental assets.
It can be very time consuming and difficult to track all the items in a rental property and depreciate them at their correct effective life. More importantly, the original building construction cost is most often unknown. For that reason, it is smart to obtain a depreciation report from a quantity surveying firm that specialises in rental property deprecation. The quantity surveying firm will correctly classify the cost of all depreciable items into tables. A tax accountant will then be able to identify the correct and most beneficial annual depreciation rate. The higher the depreciation rate, the greater the tax deduction.
“Gearing” is another word for borrowing, and negative gearing is when your total annual rental expenses exceed your rental income.
Briefly refreshing, the main way wealth is made from property is from capital gains. Gearing (borrowing) is a tool that can multiply capital gains, as you are leveraging your available money. The downside is that if you make a capital loss, gearing will multiply your loss.
So, negative gearing is only beneficial if you make a capital gain on the sale of your rental property that exceeds the total after tax annual loss. If you do make a capital gain, negative gearing is effectively multiplying your gain due to the leveraging (borrowing) effect, and also due to the annual tax deduction.
In what entity should a rental property be purchased?
As illustrated above, rental properties do not always make an overall profit. It makes sense to do some basic planning. Otherwise, you could rush into a purchase that either doesn’t make you as much money, or worse, actually loses you money.
There are two reasons why the choice of which entity to hold the property is important:
In a nutshell, asset protection is usually about protecting an asset in the event of legal action.
The choice of entity to hold the property in can alter the tax effectiveness of a rental property. In the most common scenario, an individual or a couple owns the rental property. If a couple jointly purchases a property, the net rental income or loss will be shared 50/50. This applies even if the mortgage is in the name of one spouse. It is possible to purchase as tenants in common – in this case the ownership % can vary. It can’t be changed however, without doing a legal transfer (and likely incurring transfer duty).
The tax effectiveness of a rental property will vary depending on the marginal tax rate of the owner. If you are a couple considering purchasing a rental property, it is worth considering whose name to purchase the property in. For example, if one of you earns significantly more than the other, the higher income earner will have a higher marginal tax rate. If the property is negatively geared (which is likely), it would (at least initially) be more beneficial to purchase the property in the name of the higher income earner, as he/she will get more benefit from the net rental loss (tax deduction). Keep in mind however, that most properties turn cash flow positive. In other words, eventually the mortgage is paid off and there is a net rental income instead of a loss. When this happens, it is worse to have the property in the name of the higher income earner.
It is not always a good idea to purchase a highly negatively geared rental property in a trust or superannuation fund, unless there is enough income from other sources flowing into the trust or superannuation fund. The reason being is that the annual net loss is not able to be distributed to the beneficiaries of the trust or superannuation fund. So, the loss is wasted until there is income that can be applied against it. As mentioned before, sometimes it is a matter of timing before a property turns cashflow positive – in that case a trust or superannuation fund may work out in the long run. Capital gains also needs to be considered and if the gain is sufficiently large, the potentially lower tax rate obtained by using a trust or super fund may be more beneficial in the long run. By way of note, a loss made by a trust or super fund can be carried forward indefinitely within the trust or super fund until there is income to offset against the loss.