Nearly 2 million Australians own one or more investment properties and many of them are at least partly motivated by the tax advantages which our tax system confers on investment property owners. Despite signs of weakening in the key Sydney and Melbourne markets, and suggestions that both sides of politics are looking closely at changing or removing some of the tax breaks, the investment market overall remains strong.
If you want to get the best tax outcome, it’s crucial to understand what you can and cannot claim. Obviously, you don’t want to miss out on deductions but nor do you want to claim for things you’re not entitled to. The downside of the relative generosity of some of the tax breaks is that the ATO polices this area vigorously and if you do overclaim, you can expect a ‘please explain’ letter from the taxman asking you to justify or change your claim. So, in order to help keep you out of trouble and to enable you to get the best outcome, here’s my guide to optimising your tax claims.
CLAIMING MORTGAGE INTEREST
Of the various items of expenditure that you might incur in running a rental property, probably the most significant is the amount you pay on your mortgage. The interest element of your mortgage repayment is deductible for tax purposes. Therefore, by gearing your property to the maximum level possible under the rules allowed by your bank, you can also maximise the interest charges you can claim as a tax deduction.
Because you can only claim the interest component on your loan, if you are paying principal and interest on your loan, you will need to calculate the interest element 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 growing 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).
In the context of rental properties, depreciable assets are those capital assets which are removable from the property such as air conditioning systems, furniture, carpets and kitchen equipment.
If you buy a depreciating asset for your rental property, an immediate deduction is available if the cost of the asset is less than $300. This might cover assets like toasters, kettles, small TV sets, etc.
If the depreciating asset costs less than $1,000 it will be added to a low value pool and depreciated over 4 years at a rate of 18.75% in the year of acquisition and 37.5% in subsequent years.
Depreciating assets costing more than $1,000 are written off over their effective life. You can either use the ATO’s annual tax ruling for determining the effective life of a depreciating asset (the current one is TR2017/2) or you can self-assess the effective life.
TIP: From 1 July 2017, there are major changes to the deductions allowable for depreciation. Plant and equipment depreciation deductions are restricted to expenses actually incurred by investors in residential real estate properties. Investors who purchase plant and equipment for their residential investment property after 9 May 2017 will be able to claim a deduction over the effective life of the asset. However, subsequent owners of a property will be unable to claim deductions for plant and equipment purchased by a previous owner of that property. So, if you have purchased an existing residential property after 9 May 2017, you won’t be able to claim a deduction for any plant and equipment which was already in the property when you bought it – but you will be able to claim for any new plant and equipment which you install after purchase.
You can also often claim a deduction over time for the cost of the house itself. This is a capital works deduction.
A deduction will generally be available for any rental property where construction commenced after 21 August 1984. The rate is 4% (so the cost of the building is written off over 25 years) if construction commenced before 15 September 1987 and 2.5% for all rental properties constructed since then (so the cost of the building is written off over 40 years).
As well as the cost of the building (but not the land), you can also claim capital works deductions on subsequent structural improvements to the property, such as extensions or renovations, as well as on capital assets which become part of the structure of the house, such as driveways and retaining walls.
If you buy an existing property, you can carry on writing off the cost of capital works over the remaining tax life of the building.
TIP: It can be difficult ensuring that every asset you’re entitled to claim for is included and also that each asset is correctly treated as either a deprecating asset or a capital works item. Many people choose to engage a quantity surveyor to produce a deprecation report each year when preparing their tax return.
There are lots of other things you can claim, some more obscure than others. If any of these apply to you, make sure you include them in your tax return:
- Advertising for tenants, including costs passed on by letting agents.
- Cleaning at the end of a tenancy (including removal of rubbish).
- Estate and letting agents (including management fees).
- Gardening and lawn mowing (including felling or pruning trees).
- Secretary and bookkeeping fees associated with the collection of rent and payment of property expenses.
- Repairs to your property and ongoing maintenance
- Bank charges on the account used to receive rent and pay expenses.
- Council rates and land tax.
- Insurance (building, contents or public liability).
- Credit checks.
- Pest control.
- Bank or solicitor fees for keeping title documents safe.
- Taxation advice relating to the property
- Legal expenses to eject a tenant for non-payment of rent.
- Hiring a debt collector to collect rent arrears.
- Getting new keys cut.
- Servicing items such as hot water heaters, smoke alarms, air-conditioning systems and garage door mechanisms.
- Water supply charges (to the extent that they aren’t paid by the tenant).
- Quantity surveyor.
- Security patrols.
- Security system monitoring and maintenance.
WHAT YOU CAN”T CLAIM
From 1 July 2017, you can no longer claim deductions for travel expenses related to inspecting, maintaining or collecting rent for a residential rental property. Prior to that date, the costs of traveling to and from an income producing property were usually deductible.
AND DON’T FORGET TO CLAIM THESE:
As well as the deductions mentioned above, you may not know that you can claim for the following:
- Prepaid expenses. If you pay an item of expenditure this year that wholly or partly relates to next year, you can a claim a deduction for the full amount this year. This is particularly useful with expenses that straddle the tax year, such as insurance policies or subscriptions. Example: Joe purchases buildings insurance on March 1, 2017, for his rental property. The policy runs until February 28, 2018, and costs $500. Even though only four-twelfths of the expenditure relates to the 2016-17 tax year, he can claim the whole $500 in that year since that is the year he incurred the expense.
- If you use your home phone, computer or internet services, or your mobile phone as part of the management of your investment property you can claim an appropriate proportion as a tax deduction.
Avoid trouble with the tax office
Finally here are some tips for avoiding common mistakes which get people into hot water with the ATO:
- Generally, repairs and maintenance costs are allowable for tax but be very careful if you’re claiming costs in the first 12 months of ownership. The ATO often seeks to deny instant deductions in this scenario on the basis that such “repairs” are often of a capital nature, being repairs done to rectify defects that existed when the property was acquired.
- To claim deductions, you need to let the property on a commercial basis. If the property is being let rent free (or at a non-commercial rate) to, say, friends or family, the amount of deductions you can claim will be limited to the amount of rental income you earned.
- Always keep detailed records of all income and expenses. If the ATO reviews or audits your tax return, you will need your supporting documentation to justify your deduction claims. Normally you need to keep records for five years from the date you lodged your tax return but for capital gains tax purposes, you should keep purchase and sale documentation (with details of any capital improvements) for at least five years from the date of lodging the return showing the disposal of the property. Given that you may retain ownership of the property for a long period, that means that your purchase documentation in particular will need to be stored safely for many years.
By Mark Chapman, Director of Tax Communications, H&R Block
The content above has been prepared by H&R Block Ltd (“H&R Block”), ABN 89064268 800.The above information is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice. Although every effort has been made to verify the accuracy of the information contained above, H&R Block, its officers, employees and agents disclaim all liability (except for any liability which by law cannot be excluded), for any error, inaccuracy in, or omission from the information contained on this website or any loss or damage suffered by any person directly or indirectly through relying on this information. H&R Block Ltd ABN 89 064 268 800 is a Corporate Authorised Representative No. 001246230 of Accountable Financial Solutions Pty Ltd ABN 36 146 520 390 AFSL No. 409424