Structuring your property investment: getting it right for tax

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Structuring the purchase

If you are looking to buy a property with somebody else, perhaps a spouse, another relative or simply a business partner, it’s essential to make sure you structure the transaction correctly, particularly if each party is contributing a different amount.

If the property is owned by more than one person, rental income and expenses must be split between each co-owner according to their legal ownership interest in the property. Generally, taxpayers own a property either as joint tenants or tenants-in common. They sound similar but the tax implications of each can be profoundly different:

“Joint tenants”: The owners share in all aspects of the property asset equally. If two people hold equal shares in a property as joint tenants, any separate agreement that deductions be claimed on the basis of a different ratio would be ineffective for tax purposes. If, under this arrangement, one partner assumes greater financial liability than another, that is regarded as a private arrangement by the ATO and therefore the portion of expenses claimed which exceed the 50% partnership share would not be deductible. So, if you are planning to invest in a different proportion from your co-investor, you should instead be looking to structure the transaction as tenants-in common.

TIP: Husbands and wives who buy investment properties together are joint tenants and are treated for tax purposes as sharing in income and deductions equally. Any argument that one spouse has contributed more and should therefore be entitled to a greater share in any deductions (an argument commonly made where one spouse pays tax at a higher rate than the other) will fall on deaf ears with the ATO.

“Tenants-in-common”: Each owner may hold an unequal interest in the property, for example 60% for one and 40% for the other. Where the owners hold the property as tenants-in-common, each owner holds their share of the asset outright, will be taxed on income and will receive relief for deductions based on their proportion of the investment (60:40 in this example).

Structuring borrowings

The basic rule when borrowing to purchase an investment property is that interest charges on a loan to acquire the property are tax deductible while principal or capital repayments are not.

Only the interest component directly related to your property is tax deductible. If you are paying principal and interest on your loan, you will need to calculate the interest component each year based on your loan statements.

In addition to interest relating to the property acquisition, you can also claim a deduction for interest on loans taken out to:

  • carry out renovations;
  • purchase depreciating assets (for example, furniture);
  • make repairs or carry out maintenance; or
  • purchase land on which a property is to be built.

It’s common for financial institutions to offer redraw facilities against existing loans, which investors sometimes use to purchase investment properties. Such a redraw may be used for income-producing purposes, non-income-producing purposes or a mixture of the two. In the latter case, the interest on the loan must be apportioned between the deductible and non-deductible components, with the split reflecting the amounts borrowed for the rental property and the amount borrowed for private purposes.

Tip: Try to avoid mixing loan accounts that have both deductible and non-deductible components. In the past, so-called “split loans” were popular, whereby a loan was taken out with one component servicing an investment property and another component servicing a private borrowing – a mortgage on the family home, for example. It was therefore possible to channel all the cash repayments against the private borrowing (where the interest is not tax deductible) while maintaining a high balance on the investment part of the loan (where the interest is deductible). The ATO has challenged such arrangements in the courts and that strategy to minimise tax is no longer allowed.

However, it is possible to take out two loans with the same financial institution, each maintained independently: one in relation to the investment and one in relation to the private property. By making greater repayments against the private loan, a similar tax outcome can be achieved as with the split-loan scheme but at much lower tax risk.

Example: Barbara refinances her investment property and her family home with her bank. She takes out an interest-only mortgage on the investment property and pays the minimum necessary to meet her commitments to the bank. She takes out a principal-and-interest mortgage on the family home and maximises her payments every month in order to reduce the principal outstanding (and hence, over time, reduce the non-deductible interest payments).

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