Investment Property Tax
When investing in an investment property, it is essential to realise that tax isn’t the most important factor. The tax “tail” should not wag the investment “dog” – it should be the other way around. The most important factor is to buy a property that will increase in value as much as possible. This sounds obvious, but it is surprising how many people invest in investment properties with the main aim of “getting a tax break”, otherwise known as negative gearing.
“Gearing” is another name for borrowing. Negative gearing is when your total annual rental expenses for tax purposes exceed your rental income, resulting in a loss (negative income). 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.
To summarise, tax is not the number one factor when investing, but it is still very important and if you understand how tax affects investment properties, you can often increase your overall return on investment (ROI).
Investment Property Purchase
Investment Property Structure
As illustrated below, investment 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 main reasons why the choice of which entity to hold the property is important:
1. Asset protection
2. Tax deductions
In a nutshell, asset protection is usually about protecting an asset in the event of legal action against you.
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 an investment property will vary depending on the marginal tax rate of the owner. If you are a couple considering purchasing an investment 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 investment 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.
Capital Gains Tax (CGT)
The most important way tax affects investment 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.
The purchase of an investment property is generally the acquisition of a capital asset. The costs of acquisition will be included in the cost base of the property. These will include:
- the price paid
- remuneration for specified professional services (e.g. conveyancing costs)
- transfer costs
- stamp duty or similar duty on the transfer of the property
- advertising costs
- valuation costs.
GST is not claimable on the purchase of a residential investment property as it is an input taxed supply.
However, if it is the acquisition of a commercial investment property, GST input tax credits can be claimed where the purchaser is registered for GST.
Investment Property Tax on Income
Rent and rental-related income is included in assessable income each year and is taxed at marginal rates. This is regardless of whether it is paid to the taxpayer or to the agent.
Rental – related income includes:
- letting or booking fees
- bond money that the taxpayer is entitled to retain
- government rebates for the purchase of depreciating assets.
The way that rental income and expenses are divided between co-owners varies depending on whether the co-owners are joint tenants or tenants in common or there is a partnership carrying on a investment property business.
Co-owners of an investment property – not in business
A person who simply co-owns an investment property or several investment properties is usually regarded as an investor who is not carrying on a rental property business, either alone or with the other co-owners. This is because of the limited scope of the rental property activities and the limited degree to which a co-owner actively participates in rental property activities.
Co-owners who are not carrying on a rental property business must divide the income and expenses for the rental property in line with their legal interest in the property.
If they own the property as:
- joint tenants, they each hold an equal interest in the property (i.e. 50% each)
- tenants in common, they may hold unequal interests in the property – for example, one may hold a 20% interest and the other an 80% interest.
Rental income and expenses must be attributed to each co-owner according to their legal interest in the property, despite any agreement between co-owners, either oral or in writing, stating otherwise.
There is no GST on rent from a residential investment property. However, 1/11th of rent from a commercial investment property must be remitted to the ATO where the landlord is registered or required to be registered for GST.
Investment Property Expenses
A deduction may be available for certain expenses incurred for the period a property is rented or is available for rent.
There are three categories of rental expenses – those for which:
- an immediate deduction is available
- a deduction is available over several income years
- deductions are not claimable.
Each of these categories is discussed below.
Immediate deductions may be claimed for the expenses of owning a rental property incurred by a taxpayer. Some of these deductible expenses include:
- advertising for tenants
- bank charges
- body corporate fees and charges*
- council rates
- electricity and gas
- gardening and lawn mowing
- in-house audio/video service charges
- public liability
- interest on loans*
- land tax
- lease costs
- stamp duty
- legal expenses (excluding capital expenses such as those relating to acquisition and disposal of the property and borrowing costs)
- mortgage discharge expenses
- pest control
- property agent’s fees and commission
- quantity surveyor’s fees
- repairs and maintenance*
- secretarial and bookkeeping fees
- security patrol fees
- servicing costs – for example, servicing a water heater
- stationery and postage
- telephone calls and rental
- tax-related expenses
- travel and car expenses
- rent collection
- inspection of property
- maintenance of property
- water charges.
Deductions with an asterisk are discussed in more detail below.
Apportionment of rental expenses
Note that apportionment of expenses may be necessary where:
- the property is available for rent for only part of the year
- only part of the property is used to earn rent, or
- the property is rented at non-commercial rates.
Body corporate fees and charges
Payments made to body corporate administration funds and general-purpose sinking funds are deductible at the time they are incurred.
However, if the body corporate requires payments to a special purpose fund to pay for capital expenditure, these levies are not deductible. Similarly, if the body corporate levies a special contribution for major capital expenses to be paid out of the general-purpose sinking fund, a deduction is not available for this special contribution amount. This is because payments to cover the cost of capital improvements or capital repairs are not deductible.
A capital works deduction under Division 43 Income Tax Assessment Act 1997 (ITAA 97) for the cost of capital improvements or capital repairs may be available once the cost has been charged to either the special purpose fund or, if a special contribution has been levied, the general-purpose sinking fund. This is discussed later.
A general-purpose sinking fund is one established to cover a variety of unspecified expenses that are likely to be incurred by the body corporate in maintaining the common property (for example, painting of the common property, repairing or replacing fixtures and fittings of the common property).
A special purpose fund is one that is established to cover a specified capital improvement to the common property which is likely to be a significant expense that cannot be covered by ongoing contributions to a general-purpose sinking fund.
Interest on loans
If a taxpayer takes out a loan to purchase a rental property, the interest charged on that loan, or a portion of the interest, can be claimed as a deduction. However, the property must be rented, or be available for rental, in the income year for which the deduction is claimed.
While the property is rented, or available for rent, interest may also be claimed on loans taken out:
- to purchase depreciating assets
- for repairs
- for renovations.
Where there are co-owners, interest on money borrowed by only one of the co-owners which is exclusively used to acquire that person’s interest in the rental property does not need to be divided between all the co-owners.
Prepaid rental property expenses – such as insurance or interest on money borrowed – that covers a period of 12 months or less are generally immediately deductible.
A prepayment that doesn’t meet these criteria and is $1,000 or more may have to be spread over two or more years.
Repairs and maintenance
Repairs generally involve a replacement or renewal of a worn out or broken part – for example, replacing some guttering damaged in a storm or part of a fence that was damaged by a falling tree branch.
Repairs to a rental property will generally be deductible if:
- the property continues to be rented on an ongoing basis, or
- the property remains available for rental but there is a short period when the property is unoccupied – for example, where unseasonable weather causes cancellations of bookings or advertising is unsuccessful in attracting tenants.
If a property is no longer rented, the cost of repairs may still be deductible provided:
- the need for the repairs is related to the period in which the property was used to produce income, and
- the property was income-producing during the income year in which the cost of repairs was incurred.
The following expenses are capital, or of a capital nature, and are not deductible:
- replacement of an entire structure or unit of property (such as a complete fence or building, a stove, kitchen cupboards or refrigerator)
- improvements, renovations, extensions and alterations, and
- initial repairs – for example, in remedying defects, damage or deterioration that existed at the date of acquisition of the property.
Expenses of a capital nature may form part of the cost base of the property for capital gains tax purposes. They may also be written off under Division 43 ITAA 97 – discussed later.
Deductions available over several income years
Expenses that may be claimed as deductions over several income years include:
- borrowing expenses
- amounts for decline in value of depreciating assets, and
- capital works deductions.
These are expenses directly incurred in taking out a loan for the property. They include loan establishment fees, title search fees and costs for preparing and filing mortgage documents – including mortgage broker fees and stamp duty charged on the mortgage.
Borrowing expenses also include other costs that the lender requires to be incurred as a condition of them lending the money for the property – such as the costs of obtaining a valuation or lender’s mortgage insurance.
Interest expenses are not borrowing expenses.
If the total borrowing expenses are more than $100, the deduction is spread over five years or the term of the loan, whichever is less. If the total deductible borrowing expenses are $100 or less, they are fully deductible in the income year they are incurred.
If the loan is repaid early and in less than five years, a deduction can be claimed for the balance of the borrowing expenses in the year of repayment.
If the loan was obtained part way through the income year, the deduction for the first year will be apportioned according to the number of days in the year that the taxpayer had the loan.
Deduction for the decline in value of depreciating assets
Decline in value (depreciation) can be claimed on rental property assets over their effective life.
Some items found in a rental property are regarded as part of the setting for the rent-producing activity and are not treated as separate assets in their own right. However, a capital works deduction may be allowed for some of these items under Division 43 ITAA 97 – discussed later.
The ATO has listed items that are commonly found in residential rental properties and set out whether they are eligible for a capital works deduction or a deduction for decline in value and, for the latter, the Commissioner’s determination of effective life – see “Rental Properties” booklet on the ATO website.
Generally, the rules in Division 40 ITAA 97 provide for the decline in value of rental property assets. There are special rules under Division 328 ITAA 97 where assets acquired for a taxable purpose may be immediately deductible in their year of purchase if their acquisition cost is less than $20,000 (proposed to reduce to $1000 at 1 July 2018 – at time of writing this article). However, those special rules are only available to small business entities (entities carrying on a business with an aggregated turnover of less than $10 million) and the only rental property assets that might qualify are those where there is a short-term lease.
Although generally depreciation is claimed on rental property assets over their effective life, there is a special exception for certain depreciating assets that satisfy the requirements below. An immediate deduction is available for the cost of those assets where they meet all the following tests:
- costs $300 or less
- is used mainly for the purpose of producing assessable income that is not income from carrying on a business (for example, rental income where the rental activities do not amount to the carrying on of a business)
- is not part of a set of assets that costs more than $300
- is not one of several identical or substantially identical assets acquired in the income year that together cost more than $300.
Low-cost assets and low-value assets relating to the rental activity can be allocated to a low-value pool and benefit from accelerated depreciation.
A low-cost asset is a depreciating asset whose cost is less than $1,000 as at the end of the income year in which it is used, or installed ready for use, for a taxable purpose.
A low-value asset is a depreciating asset that is not a low-cost asset and:
- that has an opening adjustable value for the current year of less than $1,000, and
- for which the taxpayer has used the diminishing value method to work out any deductions for decline in value for a previous income year.
The decline in value of depreciating assets in a low-value pool is based on a diminishing value rate of 37.5%.
For the income year a low-cost asset is allocated to the pool, work out its decline in value at a rate of 18.75%, or half the pool rate.
Capital works – Division 43 ITAA 97
A 2.5% or 4% annual capital works deduction can be claimed in relation to most rental properties if they were constructed after Aug 1979. The amount claimable depends on the date of construction and the construction expenditure.
The deduction becomes available when the construction is completed and is based on the costs of the construction. Where the costs cannot be determined, an estimate by a quantity surveyor or other reasonably qualified person can be used.
Deductions based on construction expenditure also apply to capital works such as:
- a building or an extension – for example, adding a room, garage, patio or pergola
- alterations – such as removing or adding an internal wall, or
- structural improvements to the property – for example, adding a gazebo, carport, sealed driveway, retaining wall or fence.
Deductions can only be claimed for the period during the year that the property is rented or is available for rent.
Where ownership of the building changes, the right to claim any undeducted construction expenditure for capital works passes to the new owner. The claim is apportioned for days held.
Be aware that deductions that have been allowed under Division 43 are removed from the cost base on disposal. This affects assets acquired after 13 May 1997.
The taxpayer acquired an income producing property (land and buildings) for $1 million after 13 May 1997. The taxpayer then spent $250,000 on altering and improving the building.
The taxpayer sold the property 3 years later for $3 million.
In respect of the ownership period, the taxpayer was entitled to deduct, under Division 43 ITAA 1997, a portion of the capital works expenditure incurred in altering and improving the building and a portion of the expenditure incurred by the previous owner in constructing the building. The total amount the taxpayer deducted was $20,000, which was the total amount allowed under Division 43.
The taxpayer did not have a profit-making intention and was not in the business of buying and selling properties.
In working out the capital gain on disposal of the property, the cost base for the taxpayer will be the $1m + $250,000 less the $20,000 claimed under Division 43 = $1,230,000.
Deductions not claimable
Expenses for which deductions are not claimable include:
- acquisition and disposal costs – these are considered in determining any capital gain or loss on disposal of the property
- expenses not actually incurred by the taxpayer, such as water or electricity charges borne by the tenants, and
- expenses that are not related to the rental of a property, such as expenses connected to private use of a holiday home that is rented out for part of the year.
Restriction on depreciation deductions for residential investment properties
With effect 1 July 2017, new section 40-27 ITAA 97 disallows depreciation deductions for “previously used” i.e. second-hand assets used in residential rental properties. The section applies to income years starting on or after 1 July 2017 to assets acquired at or after 9 May 2017 unless the asset was acquired under a contract entered before this time. The section also applies to assets acquired before this time if the assets were not used for a taxable purpose in earlier income years.
The decline in value of the asset that cannot be deducted is recognised as a capital loss or gain when the asset ceases to be used.
An asset is “previously used” if:
- if there has been any prior use of the asset by another entity, other than use as trading stock;
- the asset is used or installed ready for use during any income year in premises that are, at that time, a residence of the taxpayer; or
- the asset is used or installed ready for use during any income year for a purpose that is not a taxable purpose, other than incidental or occasional use.
Craig has acquired an apartment that he intends to offer for rent. This apartment is three years old and has been used as a residence for most of this time.
Craig acquires a number of depreciating assets together with the apartment, including carpet that was installed by the previous owner. He also acquires several depreciating assets to install in the apartment immediately prior to renting it out, including:
- curtains, which he purchases new from Retailer Co; and
- a washing machine, that he purchases used from a friend, Jo.
Craig also purchases a new fridge, but rather than place this in the apartment, he uses it to replace his personal fridge, that he acquired several years ago for use in his residence. He instead places his old fridge in the new apartment.
Craig cannot deduct an amount under Division 40 (or Div. 328) for the decline in value of the carpet, washing machine or fridge for their use in generating assessable income from the use of his apartment as a rental property as they are previously used. The carpet and washing machine are previously used as the previous owner or Jo rather than Craig first used or installed the assets (other than as trading stock). The fridge is previously used as while Craig first used or installed the fridge, he has used it in premises that were his residence at that time.
Craig can deduct an amount under Division 40 for the decline in value of the curtains. They are not ‘previously used’ under either limb of the definition.
Section 40-27 does not apply if:
(a) the asset is installed in premises supplied as new residential premises, including substantially renovated premises, if no entity has previously been entitled to any deduction for the decline in value of the asset and either:
- no one resided in residential premises in which the asset has been used before it was held by the current owner; or
- the asset was used or installed in new residential premises (or related real property) that were supplied to the taxpayer within 6 months of the premises becoming new residential premises, and the asset had not been previously used or installed in a residence; or
(b) the asset is used in carrying on a business;
(c) the taxpayer is a corporate tax entity;
(d) the taxpayer is an institutional investor, i.e. a superannuation fund that is not a self-managed fund, a managed investment trust or a public unit trust; or
(e) the taxpayer is a unit trust or partnership, provided each member of the trust or partnership is one of the entities described in (c) or (d) above.
Section 40-27 does not affect the claiming of Div. 43 capital allowance deductions.
Investment Property Sale
Selling the rental property will result in a capital gain or loss equal to the consideration received on disposal less the cost base.
The cost base will include not only the costs of acquisition but also the costs of sale. For example:
- remuneration for specified professional services
- transfer costs
- advertising costs
- valuation costs
- any costs of ownership which are not deductible (for assets acquired after 20 August 1991)
- expenditure of a capital nature incurred for the purpose of increasing or preserving the value of the asset.
In working out a capital gain or capital loss from a rental property, remember to exclude from the cost base the amount of capital works deductions claimed if:
- the property was acquired after 7.30pm on 13 May 1997, or
- the property was acquired before that time and the expenditure that gave rise to the capital works deductions was incurred after 30 June 1999.
GST is not payable on the sale of a residential rental property as it is an input taxed supply. However, if the sale is of a commercial rental property, GST must be paid to the ATO of 1/11th of the proceeds on sale. In this case, input tax credits should be available for the GST paid on the costs of sale (e.g. legal and real estate agent fees). The GST exclusive costs will be included in cost base.
How we can help
At Bristax, investment property tax is one of our specialist areas. Our tax accountants would be happy to speak or meet with you to discuss your situation. We’ll take the time to understand your circumstances and provide advice that maximises your financial position.
You can contact us on 1300 883 597. We have offices in Brisbane, Sydney and Melbourne and provide full tax and accounting services Australia wide via internet, email and phone.