Every dollar you can claim on an investment property will benefit your financial well being. With this in mind, the team at Your Investment Property asked Eddie Chung to clarify what you can and cannot claim on negatively geared investments.
One of the most popular wealth creation strategies is negative-gearing investment properties. The net loss generated can be offset against other income, reducing the tax that would otherwise be payable on that income. The investor is essentially punting on the capital gain outweighing the cumulative losses incurred. It has worked for many people as property values are meant to double every seven to 10 years according to conventional financial wisdom.
Naturally, the more deductions investors can claim on a property, the higher their tax benefit. As a property investor, it is important to claim as many deductions as you are legally entitled to. Every tax dollar you save goes towards your overall investment return and financial wealth.
The following are some of the most common tax deductions you can claim on your investment property and the rules surrounding how they can be claimed.
Interest is by far the largest tax deduction in a negative gearing arrangement. Provided your property is available for rent, the interest incurred on money you’ve borrowed for the property is tax-deductible, including money used to purchase the property, undertake repairs and improvements, or deal with tenant related issues.
The kind of security put up for the loan does not affect the deductibility of the interest at all. Just because your investment property loan is secured by your home does not affect the tax deduction available on the interest.
However, the deduction is only available to the extent that the borrowed monies are used for income producing purposes. If the monies were applied for both private and income producing purposes, apportion nment of the interest will be necessary to determine the tax-deductible portion. For instance, if a loan was drawn down to purchase a home and a rental property, only the interest that is attributable to the rental property will be tax-deductible. Similarly, if a loan was taken out to purchase a single property that is used partly for rental and partly for private purposes, only the interest related to the rental portion will be deductible.
2. Tenancy costs
The cost of advertising for tenants is tax-deductible, so are letting fees paid to property managers who procure tenants on your behalf. Any expense incurred in relation to preparing or varying the lease with your tenant is also tax-deductible, even though such expenditure is usually considered capital in nature.
In contrast, costs incurred to purchase new depreciating assets (such as a dishwasher or clothes dryer) and structural improvements to the building to make the property more attractive to prospective tenants are capital and not tax-deductible, though such costs will be eligible for depreciation and capital works deduction claims. Landlord insurance premiums are also tax-deductible as a general rule, as are legal costs required to evict a tenant.
A deductible cost that is often overlooked is travelling to inspect the property. For properties within the vicinity of the landlord’s home, the landlord may claim motor vehicle deductions on the inspection trips. For properties at longer distances, he may even claim airfares.
Any costs claimed must be wholly attributable to the property inspection. If other purposes exist, such as going on a holiday, then apportionment of the travelling costs to determine the deductible portion will be required. Reasonably strict substantiation rules apply to travelling costs, so make sure you keep all your receipts, invoices, and a travel diary.
3. Repairs and maintenance
The cost of restoring something to its original condition due to tenant wear and tear is tax-deductible, provided it is not “initial repairs” – damage that existed when the property was purchased.
Initial repair costs are generally considered capital in nature and are included in the cost base of the property or the cost of a depreciating asset, depending on the nature of the repair work done. These costs may in some cases qualify for a depreciation or capital works deduction.
It is interesting to note the difference between a repair and an improvement. The former is revenue in nature and is deductable. The latter is capital in nature and cannot be claimed. That said, the cost of an improvement may qualify for a depreciation or capital works deduction.
The cost of restoring something over and beyond its original condition would normally constitute an improvement. This changes if the restoration work involves the use of a modern equivalent of the original material that surpasses its predecessor in quality and longevity. In those cases, the work will be considered a repair.
Other improvements include replacing an entire functional unit, which is viewed as capital in nature. Again, such costs may be eligible for a depreciation or capital works deduction.
By way of examples, tax-deductible repair costs that are not attributable to initial repairs include fixing a leaking tap, repainting damaged walls, replacing damaged guttering, or fixing a dishwasher that has stopped working. An example of an improvement is replacing a laminated kitchen bench top with a granite bench top.
More often than not, it may be difficult to tell if the work done on a property was a repair or an improvement, which is why the Australian Taxation Office conducts routine reviews of repairs and maintenance deduction claims on rental properties. It is advisable that you insist on detailed invoices from any tradespeople you use which clearly state the nature of work done. Also try to be patient with your accountant. If they seem over-analytical in how they query your repairs and maintenance costs, bear in mind that they are just trying to ensure that your claims pass the scrutiny of the taxman.
4. Depreciating assets
Depreciating assets are stand-alone functional units that are not generally affixed to the building that decease in value over time. Examples include clothes dryers, dishwashers, curtains and carpets. While the cost of buying a depreciating asset is not, in general, tax-deductible upfront, the cost may be depreciated over the effective life of the asset and claimed as a tax deduction over a number of years. The tax office provides suggested depreciation rates for different assets but you are allowed to self-estimate the effective life of a specific asset, as long as you can justify it. You may also depreciate the asset at either the prime cost method or the diminishing value method.
An exception to the rule is if the cost of the depreciating asset is less than $300 and your property investments do not constitute a leasing business (which would only be so if you have multiple properties and tenancies and the scale and extent of your leasing activities amount to a business), in which case the cost will be immediately deductible. For completeness, if a GST input tax credit has been claimed on the cost (for example, if you have a commercial property), it is the GST-exclusive amount that is relevant in determining if the cost exceeds $300. Otherwise, the $300 limit applies to the GST-inclusive amount.
If the asset is part of a set of assets that are substantially identical and bought at the same time (say, a set of dining chairs), the immediate write-off will not be available if the cost of each individual asset does not exceed $300, even if the entire set costs more than that amount.
The cost of solar panels and a solar hot water system is depreciable. Any government rebate you receive for these purchases will need to be included in your assessable income. If you (as opposed to your tenants) receive a credit or an amount for supplying power generated from your solar panels in your investment property to the grid, the credit or amount will be taxable in your hands.
5. Capital works
Capital works expenses are generally not tax-deductible upfront. Unlike depreciating assets, capital works are generally done on things that are affixed to and become part of the land and building, such as an extension, structural alteration or and structural improvement, such as a retaining wall or a sealed driveway.
The construction expenditure incurred on the work can generally be claimed at 2.5% per year on a straight-line basis over 40 years (a 4% rate over 25 years applies to short term travellers accommodation where the property has at least 10 bedrooms) and the claim is available once the construction work is completed on the rental property. It should be noted, however, that demolition, landscaping, and land clearing costs are not included in construction expenditure and are not eligible for the claim.
Capital works deduction claims have timing conditions – you can only claim on the construction expenditure on the building itself if the construction work started on or after July, 18, 1985. The construction expenditure on structural improvements, extensions, and alterations is only eligible for the claim if the construction work started on or after February, 27, 1992.
The construction expenditure that the capital works deduction claim is based on is not always calculated by how much you paid for the work. For capital works you incurred on a new building, you need to exclude the builder’s profit margin in calculating the construction expenditure amount that you base the capital works deduction on.
For an existing building you purchased, you need to obtain the original construction expenditure amount from the seller and claim the remaining deductions that have not been claimed by the previous property owners. Alternatively, you are allowed to engage a qualified quantity surveyor, who will provide you with a depreciation and capital works deduction report, which will provide the amount of deductions you are entitled to claim.
6. Other holding costs
Holding costs are monies that go into owning a property and include body corporate fees, cleaning costs, gardening costs, building and contents insurance premiums, rates, security monitoring costs, pest control, and property manager’s fees. These costs are generally tax-deductible upfront.
For body corporate fees, regular contributions, which include admin levies and general purpose sinking funds, are tax-deductible. Special contributions to cover specific capital works on the other hand are not tax-deductible, but can be claimed as a capital works deduction instead.
Here’s a tip: if you own a rental property in your name and it is not part of a property leasing business, you can claim a tax deduction on prepaid tax-deductible expenses, provided that the prepayment is for services within the next 12 months. For instance, if you prepay interest on your investment loan on 30 June 2012 for the period from 1 July 2012 to 30 June 2013, you will be able to claim a tax deduction for the prepayment in your tax return for the year ending 30 June 2012.
For other taxpayers (for example, if you use a family trust to own the property), a prepayment will only be immediately deductible if the expenditure is less than $1,000 or specifically required to be incurred by a law.
In any case, prepaying an expense only provides a one-off timing advantage and you need to keep doing it after the first year to ensure the benefit is not negated.
Eddie Chung is partner, tax & advisory, property & construction at BDO (Qld) Pty Ltd.
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. This article is provided on the terms and understanding that the author and BDO (QLD) Pty Ltd are not responsible for the results of any actions taken on the basis of information in this article, nor for any error in or omission from this article. The article is provided for general information only and the author and BDO (QLD) Pty Ltd are not engaged to render professional advice or services through this article.