Tax return time is fast approaching, but be sure not to make these common mistakes while you're sorting through your property investment finances or you could lose out on big cuts to your tax bill.
Eddie Chung reveals the common mistakes investors make when claiming tax deductions on their investment property:
1. Repair or improvement?
There is a fundamental difference between a repair and an improvement – the former is tax-deductible, but the latter is considered capital and therefore not tax-deductible.
An easy way to determine if something is a repair or an improvement is to ask the question – did the work done restore something back to its original condition or did it improve it to a condition that is beyond its original state? If the answer is the former, the cost will be tax-deductible, provided that the work does not constitute initial repairs. On the other hand, improving something to a state that is beyond its original condition is also capital in nature, which is not tax-deductible.
2. Non-deductible costs
Just because something is not tax-deductible does not mean it simply fades into the tax black hole and is therefore “dead money”. You need to bear in mind that any work done on a property that is capital in nature may still attract some tax perks.
If the thing acquired is a free-standing functional unit, it may be classified as a depreciating asset on which you may claim a depreciation deduction. If the thing acquired is affixed to the building, it may constitute “construction expenditure” on which you may claim a building allowance deduction. If worst comes to worst and the expenditure does not fall under either of these categories, it may still be included in the cost base of the property, which may reduce the future capital gains tax payable if the property is sold.
3. Building allowance
You are generally allowed to claim an annual building allowance of 2.5% or 4% on the construction expenditure incurred on structural improvements that is attached to land.
However, construction expenditure is not synonymous with the amount one pays to acquire the property. It is the capital expenditure originally expended to construct the building or improvement.
In other words, you cannot claim the building allowance on the contract price, for instance. Rather, you need to ask the vendor to provide you with the remaining balance of construction expenditure that may be claimed (the vendor may already have claimed some building allowance in respect of the construction expenditure).
Alternatively, a lot of people are not aware that they can buy a depreciation report from a qualified quantity surveyor to substantiate their claim, which is generally accepted by the tax office. Such a report generally costs about $500, which will pay for itself.
4. Interest is interest is interest
Most people assume that any loan drawn down that is related to their rental property is immediately tax-deductible. While this is generally true, the deductibility of interest is contingent on a strict tracing of loan funds to determine if they have been used for an income producing purpose.
For instance, if someone withdraws funds from a redraw account and uses the funds to buy a home, the interest on the funds will not be tax-deductible, even if the redraw account was originally established to buy a rental property. The purpose of the redrawn funds, in this instance, is treated as relating to the acquisition of the private residence, which will render the interest incurred on the borrowed funds non-deductible.
Another common situation is when borrowed funds are used for mixed purposes. Obviously, the interest incurred on such a loan account will not be wholly tax-deductible and an apportionment of the deductible portion of the interest is required. However, it should be noted that if any repayment is made on the loan, the repayment will also need to be apportioned between the private and income producing purposes on a reasonable basis, which may be a point of challenge by the tax office. That is why the best thing to do is always to have separate accounts for private and income producing funds.
5. Borrowing costs
Another mistake people often make is that they either include the borrowing costs associated with the acquisition of the property in its cost base or they claim the total borrowing costs outright as a tax deduction. Neither of these is the correct treatment of borrowing costs.
The correct treatment of borrowing costs is: if the amount incurred is less than $1,000, it may be claimed as an immediate tax deduction. If the amount exceeds $1,000, the amount will need to be claimed progressively over the life of the loan or 5 years, whichever is shorter.
6. Legal fees
Legal fees related to the purchase or sale of a property are included in its cost base and are not tax-deductible. However, legal costs incurred to deal with the day-to-day operation of the property, eg, drawing up a lease, disputing with tenants, etc, are tax-deductible, as is qualified professional advice and assistance that is attributable to managing your taxation affairs.
7. Body corporate fees
Most property investors seem to think that body corporate fees are categorically tax-deductible.
While this is generally true for regular body corporate fees that are essentially funds used by the body corporate manager to manage the day to day operation of the property, special levies and sinking funds that are used to fund capital improvements on the property are not tax-deductible even though they are usually included in the normal quarterly body corporate fee invoices.
8. Travelling expenses to inspect property
I cannot recall the number of times when I overheard people boasting about the tax-deductible holiday they just had as they were claiming the travelling expenses as a tax deduction on the basis that they were costs incurred to inspect their income producing property.
It is without a doubt that bona fide travelling expenses incurred by say a landlord to inspect their rental property is tax-deductible. However, the availability of the deduction is contingent on the extent of the income producing purpose behind the trip.
For instance, if your primary intention to travel to a particular location is to inspect your property but you also intend to use the opportunity to go on a holiday, there will be multiple purposes behind the trip, which means that the associated travelling expenses will need to be reasonably apportioned and only the income producing portion of the expenses should have been claimed in the tax return.
9. Available for Rent?
An expense is only tax-deductible to the extent that the property is used for an income producing purpose. Therefore, if a property is not available for rent for a part of the year, the expenses incurred on the property for that year will need to be apportioned. This apportionment is often not taken into account in the tax return, which will pose audit risks if the tax office decides to review the claims.
You need to distinguish between a property being not available for rent and a property being left vacant but is available for to rent. The latter generally does not give rise to a need to apportion the expenses because so long as the property is available for rent, its purpose remains income producing, even though it is temporarily not tenanted.
To determine if an untenanted property was available for rent, the tax office generally looks for evidence to see if the property was being actively marketed to procure tenants. Therefore, evidence such as advertising agreements with real estate agents in respect of the untenanted period will become very useful.
Residential property leasing does not attract GST, but the leasing of commercial properties does so if the landlord is registered for GST or is required to be registered for GST. That is why investors who move from investing in residential properties to commercial properties are often not aware of the GST implications of their newly acquired commercial properties.
Generally, if you own commercial properties and the combined projected annual rent of these properties will exceed $50,000, you are required to be registered for GST. This will also mean that you are automatically liable to GST on 1/11th of the gross rent, which must be paid to the tax office. On the other side of the coin, you may claim back the GST included in the expenses you incurred on your commercial properties.
In addition, there may also be GST implications associated with the purchase and sale of commercial properties. Professional advice is highly recommended, as the relevant law is relatively complex.
If you own commercial properties and are required to be registered for GST, you will need to ensure that the amounts you report in your tax return in respect of the properties are GST-exclusive.
Eddie Chung is a partner of tax and audit advisory BDO Australia.
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