Claiming a tax deduction on an investment property sometimes becomes a bit of a reflex action. Many people live under the impression that if they have incurred a cost that is related to their investment property, surely they must be entitled to claim a tax deduction on the cost. Unfortunately, the tax law is anything but simple, which can easily catch the unsuspecting. This article looks at the common mistakes investors often make in claiming tax deductions on their investment properties.
1. Claiming an expense that has not been incurred
As simple as this may seem, you can only claim a tax deduction on an expense that you have actually incurred. For example, if you spend time doing some repair work on your investment property, you cannot generally claim the time and energy you expended to do that work because you have not incurred the expense, which generally requires you to pay someone something. In contrast, the cost of the materials you use to do the repair work that is incurred at a hardware store will be tax-deductible. Likewise, if the repair work is done by someone else, then the cost of hiring that person will be tax-deductible to you.
2. Claiming the full amount of an expense with a mixed purpose
An expense is only tax-deductible to the extent that it is incurred in the course of producing assessable income or carrying on a business. The phrase 'to the extent' contemplates the requirement to apportion the deduction if the purpose behind the expense is not wholly related to an income-producing purpose.
For instance, if you draw down on a part of a line of credit account to buy your investment property and draw down another part to buy your home, only the interest expense that is attributable to the investment property part of the loan will be tax-deductible. The other part drawn down to buy your home will not be tax-deductible. Therefore, failing to apportion the interest expense relating to only the investment property and claiming the entire amount is not correct for tax purposes.
3. Claiming the expense in the wrong entity
The tax law recognises different ‘entities’ for tax purposes and the deductibility of an expense must be considered in the context of the particular entity concerned. A common example pertains to a couple who jointly borrows to buy an investment property in the name of a family trust. When interest is incurred on the loan, the interest expense is incurred by the individuals, so the family trust cannot claim the interest as a tax deduction, even if the interest is paid by the trustee of the family trust.
In these situations, the individuals should enter into a 'back to back loan' arrangement with the trust so that they are effectively on-lending the proceeds from the bank loan to the trust. This will enable the individuals to on-charge the interest on their loan to the trust, which will enable them to claim the interest paid to the bank, as the interest is related to the individuals earning interest income from the trust.
In which case, the individuals should disclose the interest income ‘paid’ to them by the trust as assessable income, and claim the interest expense paid to the bank in their individual tax returns (the ‘in and out’ should net to nil), while the trust should claim the interest paid to the individuals against the rental income it derives in its own tax return.
4. Claiming the expense in the wrong income year
With the exception of certain prepayments, you can generally only claim a tax deduction on an expense in the income year in which the expense is incurred. This could sometimes mean that you are entitled to a tax deduction even if you have not physically paid the expense. Therefore, if you discover that you have omitted to claim a tax deduction that you incurred in an earlier income year, you are required to amend the tax return for the relevant income year to make that claim (provided that you are still within the amendment period), rather than simply adding the claim to your tax return for the current year.
For instance, it is not uncommon for a land tax assessment to be issued long after the liability has been crystallised in the hands of the landowner by operation of the law. You may be liable to land tax due to your landholdings as at midnight on 31 December 2015, but if the land tax assessment is not issued until after 30 June 2016, you should still be claiming a tax deduction on the land tax in the year ending 30 June 2016 as the land tax was incurred in that income year.
On the other hand, there are special rules that may delay tax deductions for certain expenditure that you paid during the income year but relates to
a future income year. These rules are complex and may give rise to different outcomes depending on the type of entity involved and whether the entity is carrying on business or is classified as a small business entity.
A common example is prepaid interest expense that relates to the next 12 months after the current income year. Provided that you are not carrying on business, you are generally allowed to claim the prepaid interest as a tax deduction when it is incurred, even though it relates to the next income year.
5. Claiming an expense where record keeping and substantiation requirements have not been met.
You must keep sufficient records to support your claim for tax deductions. Otherwise, penalties may apply. In addition, to qualify for a tax deduction for some expenses, you are required to satisfy additional substantiation requirements.
For most expenses, you are required to keep records of the expense, eg, invoices, receipts, and other documentary evidence to support your claim, in case the ATO audits you and asks for the supporting documents. Other expenses may have specific substantiation requirements.
For instance, if you travel for the sole purpose of inspecting your rental property, you need to ensure that you meet the substantiation requirement for travelling costs before making the claim; in addition to retaining the normal documentary evidence, you need to have a travel diary for domestic travel lasting six nights or more and for all international trips regardless of their length.
6. Claiming an expense for the period during which the property was not available for rent
As discussed above, an expense is only tax-deductible to the extent that it is incurred in the course of producing assessable income or carrying on a business. Therefore, if your property is not available for rent during a period in an income year, the expenses attributable to that period will not be tax-deductible, ie, the expense should be apportioned to determine the deductible potion.
7. Claiming capital costs outright
Not all expenditure is tax-deductible. Apart from the requirement that an expense must be incurred in the course of producing assessable income or carrying on a business for the expense to be tax-deductible, the expense must not be capital, private, or domestic in nature.
Therefore, if you acquire a depreciating asset that has a limited effective life and expected to decline in value over time, the expenditure will be considered capital in nature and is therefore not outright tax-deductible, unless its effective life is 12 months or less. However, you are allowed to claim a depreciation deduction on the depreciating asset over its effective life. The ATO publishes effective life tables for most types of depreciating assets but you are also allowed to self-assess the asset's effective life but you must of course be able to defend your self-assessment.
In my experience, this is a common area for audit by the ATO, so it is important that capital costs are treated correctly for taxation purposes in your tax return.
8. Claiming capital works deduction incorrectly
As a lot of property investors would know, there are special rules for claiming tax deductions for capital works for buildings and structural improvements that are attached to land. While land generally appreciates in value, the physical structure will depreciate, which is covered by the capital works deduction rules.
For most people, capital works deductions are generally calculated at 2.5% of the ‘construction expenditure’ associated with the property. However, some people make the mistake of claiming 2.5% on the amount they paid for the property, which is different from the original construction expenditure of the property.
If you did not pay for the capital works or you did not obtain details
of the construction expenditure associated with the property from the previous owner, perhaps a safer way to claim capital works deductions is
to obtain a depreciation and capital works deduction report from a qualified quantity surveyor, which will generally be sufficient to defend your claim.
9. Claiming an amount that should have been included in the cost base of the property or is a ‘blackhole expenditure'
Capital expenditure need not always be costs associated with either a depreciating asset or capital works. Sometimes, the cost may simply be included in the ‘cost base’ of the property, which will be relevant when the property is eventually sold and you are required to calculate the capital gain or loss on the disposal of the property. A prime example is the stamp duty you pay to buy the property; the stamp duty is simply added to the cost base of the property.
Further, as rare as they may be, there are costs that are sometimes neither tax-deductible nor can be included in the cost base of the property. For instance, if you try to sell your investment property and incur costs in doing so but the sale is not successful and you are not holding the property in carrying on a business, the costs will become ‘blackhole expenditure’ that is neither tax-deductible nor included in the cost base of the property for capital gains tax purposes.
10. Forgetting to claim tax losses from a previous income year
While this may not be a common problem, it does rear its head every now and then. For instance, you may have incurred tax losses for a number of years as you have been negatively gearing an investment property but have not derived sufficient income to have taxable income for those years. In which case, you are entitled to carry forward the tax losses indefinitely until they are fully recouped, which often happens when you sell the property and make a capital gain on the sale.
Forgetting to claim your previous tax losses would be a big mistake as you would otherwise save cold hard cash for every dollar of tax losses you claim, so it pays to ensure that you are not wasting any of your 'hard earned' tax losses!
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