Investment property tax perks and traps


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The tax perks of owning an investment property are considerable, but there are downsides for those who don't know what they're doing. So, how exactly does our tax system treat property investors?

Understanding the basics

When you own a property and rent it out, the rental income which you earn is taxable. However, you can then deduct any expenses which you incur in generating that income.

investment properties and tax deductions

Broadly speaking, when your expenses exceed your income (ie, you make a loss), your property is negatively geared. Where your income exceeds your expenses (ie, you make a profit), your property is described as positively geared.

How deductions work

Of the various items of expenditure that you might incur in running a rental property, probably the most significant is the amount your pay on your mortgage. The interest element of your mortgage repayment is deductible for tax purposes. Therefore, by gearing your property to the maximum level possible under the rules allowed by your bank, you can also maximise the interest charges you can claim as a tax deduction.

In a common negative gearing scenario, the amounts you earn in rent are less than the amounts you spend on your rental property, including mortgage interest plus all the other expenses you can claim a tax deduction for such as:

  • land rates
  • water rates
  • estate agent fees
  • advertising for tenants
  • pest control charges
  • insurance
  • gardening and lawn mowing
  • depreciation on the cost of the building (for houses built post-1985)
  • repair and maintenance costs
  • body corporate fees
  • cleaning fees

That means that you've made a loss on your rental property and the tax law allows you to offset that loss against your other income in the year.

When you lodge your tax return, the resulting loss will often result in a significant refund of tax.

Getting your tax right

As well as the obvious deductions listed above, you may not know that you can claim for the following:

  • Prepaid expenses. If you pay an item of expenditure this year which wholly or partly relates to next year, you can a claim a deduction for the full amount this year. This is particularly useful with expenses that straddle the tax year like insurance policies or subscriptions.
  • If you use your home phone, computer or internet services, or your mobile phone, as part of the management of your investment property, you can claim an appropriate proportion as a tax deduction

And a few tips on how to avoid trouble with the ATO:

  • Generally speaking repairs and maintenance costs are allowable for tax but be very careful if you're claiming costs that relate to an issue that arose before you purchased the property. The ATO often seeks to deny instant deductions in this scenario on the basis that such "repairs" are often of a capital nature, being repairs done to rectify defects that existed when the property was acquired.
  • In order to claim deductions, you need to let the property on a commercial basis. If the property is being let rent-free (or at a non-commercial rate) to, say, friends or family, the amount of deductions you can claim will be limited to the amount of rental income you earned.
  • Always keep detailed records of all income and expenses.  If the ATO reviews or audits your tax return, you will need your supporting documentation to justify your deduction claims. Normally, you need to keep records for five years from the date you lodged your tax return but for Capital Gains Tax purposes (see below), you should keep purchase and sale documentation (together with details of any capital improvements) for at least five years from the date of lodging the return showing the disposal of the property. Given that you may retain ownership of the property for a long period, that means that your purchase documentation in particular will need to be stored safely for many years.

Capital gains on investment properties

When you sell the property, you are subject to capital gains tax (CGT) on the profit. In very simple terms the profit is the difference between your sale proceeds (less costs of sale such as legal and estate agency fees) and what you paid for it (including stamp duty and other purchase costs such as legal fees). CGT is levied at your marginal tax rate (between 19% and 45%) on the resulting profit. But, if you own the property for more than 12 months, you become eligible for the 50% CGT discount. This basically halves the amount which is subject to tax, and is equivalent to halving the rate of tax you pay on the full gain.

Example: Joe purchases an investment property in Sydney for $500,000 in 2010. He sells the property in 2022 for $1,000,000. Ignoring costs of purchase and sale, he has made a capital gain of $500,000. Because he has owned the property for more than 12 months, he is eligible for the CGT 50% discount, which reduces his taxable gain to $250,000. He pays tax on this figure at his marginal rate.

So, back to negative gearing...

Where people make money from negative gearing is on the potentially favourable interaction between the ongoing losses on the rental income and the profit which hopefully will arise on disposal of the property.

In short, you make a series of small, annual losses on your rental income (for which you receive tax relief at your marginal rate) but then at the end, you make a potentially large capital profit on the disposal (which is taxed at half rates, effectively). The profit on disposal often outweighs the small, cumulative losses on rental income. Overall, therefore, you have made a positive total return on your investment.

But take care. Without careful planning, housing investments can go wrong. You should always take detailed tax advice before entering the world of property investment.

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Mark Chapman is director of tax communications at H&R Block, Australia's largest firm of tax accountants, and is a regular contributor to Money. Mark is a Chartered Accountant, CPA and Chartered Tax Adviser and holds a Masters of Tax Law from the University of New South Wales. Previously, he was a tax adviser for over 20 years, specialising in individual and small business tax, in both the UK and Australia. As well as operating his own private practice, Mark spent seven years as a Senior Director with the Australian Taxation Office. He is the author of Life and Taxes: A Look at Life Through Tax.