IN THIS ARTICLE
- What is negative gearing?
- Purchasing an investment property
- Investment property CGT & GST
- Investment property and income tax
- Investment property tax deductions
WHAT IS NEGATIVE GEARING?
When purchasing an investment property, it’s 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’s surprising how many people invest in an investment property 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).
PURCHASING AN INVESTMENT PROPERTY
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:
- Asset protection
- 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.
SHOULD YOU PURCHASE AN INVESTMENT PROPERTY IN A TRUST OR AN SMSF?
It is not always a good idea to purchase a highly negatively geared investment property in a trust or SMSF (self managed superannuation fund) unless there is enough income from other sources flowing into the trust or SMSF. The reason being is that the annual net loss is not able to be distributed to the beneficiaries of the trust or SMSF. 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 cash flow positive – in that case, a trust or SMSF may work out in the long run. Capital gains also need 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 SMSF can be carried forward indefinitely within the trust or SMSF until there is income to offset the loss.
INVESTMENT PROPERTY CGT & GST
The most important way tax affects investment properties is regarding CGT (Capital Gains Tax). CGT is not a separate tax besides income tax – CGT is 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 base of the asset. The capital gain is added on to any other income earned and taxed at the relevant income tax rate.
The CGT cost base will include not only the costs of acquisition but also the costs of sale. Here are some typical costs which can be included in the cost base:
- remuneration for specified professional services
- transfer costs
- advertising costs
- valuation costs
- any costs of ownership which are not deductible
- expenditure of a capital nature incurred to increase or preserve 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 7.30 pm 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.
THE 50% CAPITAL GAINS TAX DISCOUNT CONCESSION
An extremely 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 shortly though).
As an overall wealth-building strategy, it’s 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.
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.
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 investment property, GST must be paid to the ATO of 1/11th of the proceeds on the 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 the cost base.
INVESTMENT PROPERTY AND INCOME TAX
- letting or booking fees
- bond money that the taxpayer is entitled to retain
- government rebates for the purchase of depreciating assets
CO-OWNERSHIP OF AN INVESTMENT PROPERTY
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 if there is a partnership carrying on an investment property business.
CO-OWNERS OF AN INVESTMENT PROPERTY: NOT IN THE 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.
RENTAL INCOME AND GST
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 TAX DEDUCTIONS
In this section, read about rental expenses, body corporate fees and charges, loan interest, and immediate deductions.
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 – 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:
*Discussed in detail below.
Travel and car expenses
WHEN DO YOU NEED TO APPORTION 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.
ABOUT PREPAID RENTAL PROPERTY EXPENSES
Prepaid rental property expenses – such as insurance or interest on money borrowed – that cover 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.
BODY CORPORATE FEES AND OTHER 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 special 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.
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 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.
A NOTE ON STRATA FEES AND SPECIAL LEVIES
1. What is Strata?
The structure established to handle the legal ownership of a piece of a building is known as a strata scheme. In essence, it means that even though you own your own flat, you jointly own the building with other residents. These structures come in both residential and commercial varieties.
The collective group of tenants in a strata building is referred to as the “owners corporation.” They are both accountable for maintaining the building and the common areas.
‘Body corporate’ refers to the organization that controls a building that is part of a strata scheme. You are required to make payments to the body corporate as the owner of a piece of the building. These payments are referred to as strata fees.
2. Are strata fees tax deductible?
Typically, strata fees are tax deductible. You should be able to provide specifics on what can be claimed as long as you maintain a broad record of expenses made on your property.
You can typically claim a deduction if the cost is included in the administrative or sinking fund. However, these fees aren’t deductible if a cost is deemed to be for a specific purpose in relation to a capital expenditure.
3. What is a special levy?
A special levy is introduced on an as-needed basis to cover emergency and unexpected expenses. This is on top of the general- and special-purpose sinking funds.
4. Is a special levy tax deductible?
A special levy is not tax-deductible. Only administrative and general purpose sinking funds are deductible. Special levy contributions go toward the price of capital upgrades or repairs of a capital nature. Once the work is finished and the cost has been charged to the fund, you might be entitled to claim a capital works deduction for your share of the expense.
LOAN/MORTGAGE INTEREST EXPENSE
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.
Please see further discussion under this topic below.**
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, 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.
Some investment property tax deductions are available over several income years. The 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.
A 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 the 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 on 1 July 2018 – at the 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 to produce 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 VALUE POOLING
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 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 a decline in value for a previous income year.
The decline in the 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, working 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 undetected 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 $1m + $250,000 less the $20,000 claimed under Division 43 = $1,230,000.
NON CLAIMABLE INVESTMENT PROPERTY TAX DEDUCTIONS
- acquisition and disposal costs – these are considered in determining any capital gain or loss on disposal of the property
- expenses not 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.
RESTRICTIONS 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 taxable, 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 several depreciating assets together with the apartment, including a carpet that was installed by the previous owner. He also acquires several depreciating assets to install in the apartment immediately before 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 fridge, which 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 by 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 on 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 self-managed, 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 INTEREST EXPENSE
Section 8-1 of the Income Tax Assessment Act 1997 is the starting point for determining whether interest is deductible. The section provides that an outgoing will be deductible to the extent it is incurred to produce assessable income or in carrying on a business. The outgoing will not be deductible to the extent it is incurred for a private purpose. Whether interest is incurred in producing assessable income is determined by reference to the ‘use’ of the borrowed money.
If borrowed money is used to acquire an income-producing asset, the interest outgoing will likely be deductible as the use of the borrowed money relates to the production of assessable income via that asset. Therefore, interest on borrowed money used to acquire an investment property (i.e. an income-producing asset) that is rented (i.e. resulting in assessable income) will generally be deductible.
It is important to understand the limitations on interest deductibility. There are many traps which may cause interest payments to lose ‘deductible’ status. This article flags several of those risks.
Before addressing those risks, note the following concepts:
- Interest (like any other outgoing) is deductible when ‘incurred’. The point of time interest is ‘incurred’ is when the interest becomes due and payable.
- The purchase of the property and any principal loan repayments are generally not deductible as these payments relate to a capital asset. Outgoings of a capital nature are specifically not deductible as stated in section 8-1(2)(a) of the Act.
- This article assumes the investment property is held on capital account. The rules regarding interest deductibility may slightly vary in respect of an investment property that is held on revenue account, noting that it would be rare for an investment property to held on revenue account.
Impact of a redraw facility and / or offset account
It is very common for borrowers to either have access to a redraw facility or an offset account in respect of the investment property loan. To summarise the difference:
- A redraw facility enables the account holder to make repayments to paydown the loan balance and then to subsequently redraw the amount of surplus funds (overpayments) from the loan account. For example, Thomas borrows $1 million to purchase an investment property. He is required to make total repayments of $100,000 in the first year of the loan. However, he is eager to pay off the loan as quickly as possible and makes $300,000 in repayments. The bank permits Thomas to redraw the surplus repayments of $200,000.
- An offset facility is account linked to the primary loan that will notionally offset against the loan balance on the primary loan account to reduce required interest repayments on that primary loan. For taxation purposes, the offset account is treated as an entirely separate account from the primary loan account.
Unbeknownst to many, there can be vastly different tax outcomes when amounts are drawn-out by the taxpayer from the primary account using a redraw facility versus amounts which are drawn-out by the taxpayer from the balance of an offset account.
Amounts withdrawn from the offset account will have no impact on the deductibility of interest outgoings on the primary account. Conversely, drawings made under a redraw facility are considered to have been put to an alternative use. If that use is private in nature e.g. for a deposit on a primary residence, the interest relating to the redrawn funds will NOT be deductible.
Following on from the previous example, Thomas takes advantage of the redraw facility on his investment property primary loan account and redraws $200,000. The redrawn amount is used as a deposit to purchase a new primary residence. As the redrawn funds are put towards a private use, any interest on the primary loan that relates to the portion of redrawn funds is not deductible.
The sharing of the interest expense between joint tenants or tenants in common
The investment property outgoings which are allowable deductions must be shared between owners according to the legal interest of each owner. For example, Thomas and Magnolia are tenant-in-common owners of an investment property with a 40% / 60% legal interest respectively.
Thomas will be entitled to a 40% share in the interest expense deduction and Magnolia will be entitled to 60%. In this way, Thomas or Magnolia may not hoard the entire interest deduction for themselves. Joint tenants are treated the same as tenants in common except that the legal interest of each owner will be split evenly.
If Thomas and Magnolia were joint tenants both would be entitled to a 50% share of the investment property interest deductions.
Interest may be limited to return on investment
Interest may be limited to the amount of return on investment. For example, if a rental property earns $50,000 in annual rental income and annual interest outgoings are $70,000, the $20,000 excess may be subject to further scrutiny before a deduction is allowable for that amount.
A taxpayer is not permitted to claim a deduction for interest on vacant land or land without a permanent structure ready for habitation e.g. a building under construction.
For example, David purchases a vacant block of land for $500,000. He obtained finance from a lending institution to cover the entire purchase price. He intends to construct on the land and rent out the property. In this example, until construction is completed and the property is rented or available for rent, the interest outgoings on the loan to purchase the vacant land will not be deductible.
Note that interest on any part of a loan financing the cost of construction is generally deductible if the intention is for the property to be rented. For example, assume David has a separate loan for $300,000 to cover construction costs. The interest outgoings on that loan would be deductible.
Note the vacant land rules do not apply where the taxpayer that owns the vacant land is carrying on a business of property development or where the taxpayer is a company.
Linked or split arrangements
A linked or split loan facility involves at least two loans or sub-accounts. One sub-account could relate to a private purpose and another could relate to an income-producing purpose. Under these arrangements, the repayments can be allocated to the private account and the unpaid interest on the income-producing account can be capitalised to create an ‘interest on interest’ effect. This results in a favourable tax outcome for the taxpayer as the amount of deductible interest is maximised and the amount of non deductible interest is minimised. Note that the ATO has suggested that such arrangements may be in breach of the anti-avoidance rules. Further advice should be sought before entering into this type of arrangement.
Property must be rented or available for rent
Interest incurred will only be deductible during the periods in which the financed asset is an income-producing asset. The asset will only be income-producing where its use enables the derivation of assessable income i.e. when it is rented. Note that an asset will still be considered income-producing where the property is not currently being rented but is openly available for rent. The taxpayer must be able to demonstrate genuine efforts to find a tenant. For example, by advertising the property.
There may be circumstances where an alternative party obtains finance and on-lends those funds. For example, an individual beneficiary of a trust may obtain finance and on-lend that to the family trust which was unable to obtain finance itself. In order for the interest to be deductible to the individual, it may be necessary for the individual to charge the trust interest on the on-lent funds, preferably at a rate that at least matches the rate charged by the financier to the borrower. This will limit the risk of part or all of the interest outgoings not being deductible.
Private use of investment property
The borrowing of money to purchase an asset which is not income producing e.g. a primary residence, is not deductible. A complication that commonly arises in practice is where an investment property is used for private purposes for periods of time.
For example, take David who purchased an investment property on 1 July 2023 and rented it out until 30 June 2024. On 1 July 2024 he moves into the house and uses it as his personal residence. In this instance, the borrowed funds were initially applied to purchase an income-producing asset.
However, from the 1 July 2024, the asset ceased to be income-producing. In these circumstances, an ongoing daily assessment needs to be made regarding the use of the property. Interest which is incurred during the period of time that the property is rented will be deductible. Interest incurred during the period of time that the property is used as a primary residence is not deductible. For David, interest incurred from 1 July 2023 – 30 June 2014 is deductible. Interest incurred from 1 July 2024 onwards is not deductible.
Partial private use of investment property
Interest may also be partially deductible where only part of the property is used for an income-producing purpose and the other part is not. For example, Brooke rents out the ground level of her house for the entire income year via short stay accommodation and lives on the second level. In this instance, the area of the property that is used for an income-producing purpose will determine the deductible percentage of the property. The deductible percentage should be multiplied by the interest outgoings with the calculated amount being the amount of deductible interest. In this example, the area of the property used for renting is 50% of the total property area. Therefore, Brooke may deduct 50% of the interest outgoings on the investment property loan.
Prepayment of interest
There are limitations on claiming a deduction on prepaid interest. The prepayment rules restrict the bringing forward of deductions via prepayments. Note that an eligible small business can claim a deduction on interest outgoings brought forward no more than 12 months.
Companies and trusts
The same interest deductibility analysis above generally applies equally to investment properties acquired by companies and trusts. However, note a couple of things. The vacant land rules discussed above do not apply to companies. Further, any tax loss resulting from high interest deductions will be trapped in the trust or company and may not be of benefit to the company or trust until future income years whereby stored up tax losses can be applied as a deduction against assessable income (assuming the relevant company or trust loss rules are satisfied).
Non deductible interest may be added to investment property cost base
Generally, interest which is not deductible may still be added to the CGT cost base of the investment property. This will have the effect of reducing any capital gain on the sale of the investment property.
However, because of delay in receiving the tax benefit (the tax benefit is essentially deferred until the point of sale) and the fact that the gain is likely to be reduced by the 50% CGT discount (not available to companies or properties held less than 12-months), it is generally preferrable to have interest being deductible rather than added to the cost base of the property.
HOW BRISTAX CAN HELP YOU
Investment property tax is one of BrisTax’s 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.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.