Michael Quinn examines whether prepaying interest in the current low-rate environment makes financial sense for investors.
There is a range of eligible tax deductions that can give property investors considerable tax benefits. The ones people usually know about include expenses incurred in the existing financial year, such as interest paid on money borrowed or the payment of council rates, utility bills and various other costs involved in the maintenance of an investment property. It is not so widely known that it's possible to prepay some expenses for a rental property and claim an immediate deduction.
If you prepay a rental property expense - such as insurance or interest on money borrowed - that covers a period of 12 months or less and the period ends on or before 30 June 2010, you can claim an immediate deduction for this in your 2008/09 tax return. If a prepayment does not meet these criteria and it's $1,000 or more, the deduction claim may have to be spread over two years or more. This is also the case if you manage your rental activity as a small business entity and haven't chosen to deduct certain prepaid business expenses immediately.
What is prepaid expense?
A prepaid expense is expenditure you incur for things to be done (in whole or in part) in a later income year.
If you incur expenditure for something to be done in full in the same income year, it is not a prepaid expense and the prepayment rules do not apply.
What is the 12-month rule?
If you are a small business entity, or an individual incurring deductible non-business expenditure, you can claim an immediate deduction for prepaid expenditure under the 12-month rule if the payment is incurred for an eligible service period not exceeding 12 months and the eligible service period ends in the next income year.
For example, if you choose to prepay your council rates for the 2009/10 financial year and you do so before 30 June 2009, you are eligible to claim the cost of the payment as a deduction in your 2008/09 tax return.
What is non-business expenditure?
Non-business expenditure is any expenditure you incur in gaining assessable income from activities that do not relate to carrying on a business. The most common forms of non-business expenditure are amounts incurred by individual taxpayers in gaining their assessable salary and wage income. Other examples include certain expenditure made for a rental property or shares held purely as a passive investment.
Summary of rules including the 12-month rule
- Prepaid expenditure that is subject to the tax shelter rules is apportioned over the eligible service period or 10 years, whichever is less
- If you are an individual, your prepaid non-business expenditure is immediately deductible under the 12-month rule if:
a) the eligible service period for the expenditure is 12 months or less, and
b) the period ends no later than the last day of the income year following the year in which the expenditure was incurred
- If you are an individual, you apportion your deduction for prepaid non-business expenditure over the eligible service period or 10 years, whichever is less, if the eligible service period is more than 12 months or it ends after the last day of the next income year.
Calculation of your deduction if the 12-month rule is satisfied
If you incur prepaid non-business expenditure and its eligible service period is 12 months or less, and it ends on or before the last day of the next income year, you are entitled to deduct that expenditure in the income year it was incurred.
In most cases, perhaps the most significant tax benefit can be gained from prepaying interest as this is usually the largest sum of money that's paid regularly in relation to an investment property.
It is also important to consider that you need cash available in order to prepay interest and at 5% or similar low interest rates, there may be better uses for your spare funds.
Additionally, at interest rate levels of 4% or 5% such as the market is currently offering, taxpayers should consult their accountant to discuss fixing their interest rates as we are approaching 40-year lows and this could provide some welcome stability in terms of future interest payments.
This information and examples are intended to provide general information in regard to the prepaying of interest and the potential tax savings that may be made. Each individual situation is different and for this reason, it is recommended you seek the professional advice of an accountant. This ensures that you are taking the correct action to maximise your particular circumstances yet still complying with the necessary legal requirements.
Michael Quinn, Director of The Quinn Group, is an experienced lawyer, accountant and educator. As an integrated professional services firm, The Quinn Group provides the Total Solution. Clients have access to a range of services that include: Accounting and Taxation Advice, Legal Counsel as well as Financial and Investment Planning.
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