It gives most property investors great satisfaction to know that the Taxation Commissioner is picking up nearly half of every repair bill.
It seems that many people are attracted to real estate not only because of the expected investment returns but also because of the tax deductions that this class of assets creates.
But this can be a trap. Even an investor in the top income tax bracket has to spend $2.15 actual cash in order to get a tax deduction worth $1.00. In any case, the aim should always be to maximise after tax income, not to minimise tax. Notwithstanding this, there are many legitimate tax deductions specifically available to property investors, quite apart from those of a more general nature.
Eligible cash items include municipal, water and sewerage rates; land tax; fire and public liability insurance premiums; agents’ commission; advertising costs when seeking new tenants; cleaning charges and, in some cases, body corporate levies. Such items are deductible to the extent that they are the responsibility of the landlord and are not reimbursed by tenants.
However, the deductible items do not include the costs of renovations and extensions, as distinct from repairs and maintenance made to restore objects to their original condition.
Nor do eligible items include the initial expenditure incurred at the acquisition stage, such as stamp duty and legal fees. These are regarded as capital outlays. However, for capital gains tax purposes they are regarded as part of the cost base and thus reduce the CGT incurred on any disposal down the track.
Eligible non-cash items include the special building allowance under Division 43 of the Income Tax Assessment Act 1997 – for example, 4 per cent per annum on non-residential income-producing buildings erected after 27 February 1992. This allowance applies only to buildings, not to land.
Another eligible non-cash item is depreciation. This covers certain assets which have a limited life, including carpets and especially very expensive ones, such as airconditioning and, in some cases, lifts. There are two methods, namely prime cost (straight line) – for example, 10 per cent of the original cost per annum for 10 years, and diminishing value – for example, 15 per cent of the previous year’s written down value each year.
Many investors would choose 15 per cent DV over 10 per cent PC because this gives a bigger deduction in the early years of an investment. Estate agents like to stress this, but the advantage quickly declines: for a $1000 outlay, the deduction will be $150 in the first year, $127 in the second year, $108 in the third year, and so on.
For investors using loan monies, interest becomes a tax deduction, in both negative and positive gearing situations. The former arises when the interest exceeds the net rent, creating a deduction equal to the excess. This can be offset against the investor’s income from other sources.
Many investors love this scenario, forgetting that not only is there a tax loss but also there is a real loss, which may or may not be offset by capital appreciation in future years.
It should be noted that deductibility is a function of the use of the money, not of the asset which is charged. Thus interest on a loan used to buy an investment property is deductible even if the loan is secured by a mortgage over the borrower’s home.
Capital Gains Tax
Strictly speaking, capital gains tax is not a separate tax. Rather, it is levied as part of the overall income tax system. The legislation affects realised capital gains and losses.
In contrast, unrealised gains by portfolio investors as distinct from traders are not subject to taxation.
Realised capital gains in the hands of individuals are also subject to the Medicare levy.
For assets held for less than 12 months the CGT liability is based on the excess of the sale price (net of selling expenses) over the original purchase price (including all acquisition costs). For assets held for 12 months or more the CGT liability is based on half of this excess (in the case of individuals).
The purchase price adjusted for associated capital expenses is referred to in the legislation by the technical term “cost base”.
The cost base can consist of more than one component, as, for example, when capital improvements are made to an existing property. However, expenses of a revenue nature, such as rates, taxes, repairs, interest, and so on, are disregarded.
Revenue losses, including those arising from negative gearing situations, can be offset against capital gains – but not vice versa.
Capital losses can be offset against capital gains, but not against normal income. Unused capital losses can, however, always be carried forward indefinitely and can be used as offsets against capital gains in future years.
It will be obvious from the above description of the system that the precise dates of transactions can be important for capital gains tax purposes.
Because of the 12-month rule there is an advantage in selling at a profit just after the end of the first year of ownership rather than just before.
Taxpayers are required to maintain proper records to allow them to calculate their capital gains tax liability.
For capital gains tax purposes the five-year retention period for such records needs to be measured from the date of disposal of each asset concerned.