FocusOn - Rental properties

The Australian Taxation Office has indicated that it will continue to focus on rental properties in the current year, especially the reporting of all income from properties such as holiday homes. You should continue to maintain complete records of income and expenses, substantiated with receipts and/or statements where applicable.

Negative gearing

A rental property is negatively geared if it is purchased with the assistance of borrowed funds and the net rental income, after deducting other expenses, is less than the interest on the borrowings.

The overall taxation result of a negatively geared property is a net rental loss. In this case you may be able to offset the loss against other income, such as salary and wages or business income, when you complete your tax return.

Investors are often satisfied with a net rental loss due to the expectant capital growth of the underlying asset. If the property is held for more than one year you may be able to take advantage of the 50% capital gains tax discount. This means that only 50% of any capital gain is taxable.

Claiming expenses

There are three categories of expenses:

	Expenses that cannot be claimed
	Expenses that can be claimed in the year they were incurred
	Expenses which are deductible over a number of years

Rental property expenses can only be claimed if they are incurred when the property was rented or ‘available for rent’, except for interest and other holding costs, which can be claimed from the time when the intention to develop a property for rental use is actively pursued. For a property to be available for rent, the owner must demonstrate that steps have been taken to rent the property at market rates. This can include evidence that the property was listed with a real estate agent, or advertising material aimed at attracting prospective tenants. Holiday houses that are listed with a real estate agent at inflated prices are not considered available for rent. It may also be necessary to adjust the rent for seasonal factors.

Expenses that cannot be claimed

Expenses that are not deductible include the cost of acquiring and disposing of the property and initial repairs and improvements to a property. These expenses will instead form part of the cost of the property for capital gains tax purposes.

Other non-deductible expenses include those not paid by you (such as electricity charges paid or reimbursed by the tenant) and expenses relating to when the property was used for private purposes.

Expenses that can be claimed

Common expenses that may be claimed include:

	Advertising for tenants
	Agent’s commission
	Insurance (building, contents, landlord and public liability)
	Interest on loans used to finance the property (see below)
	Rates and land tax
	Repairs and maintenance
	Gardening and garden maintenance
	Travel and car expenses to inspect or maintain the property or collect rent.

Care must be taken when determining the cost of repairing a rental property. If the ‘repair’ resulted in a significant improvement of the property it will not be fully claimable. Such improvements include renovations, extensions and alterations. Replacing an entire structure will also not be claimable. We recommend you maintain a detailed account of significant repairs made to your rental property to assist in the preparation of your tax return.

You are entitled to a tax deduction for travel expenses where the sole purpose of the trip related to the rental property. If your travel was combined with a private purpose such as a holiday, you will need to consider an apportionment of expenses as appropriate.

Expenses deductible over a number of years

There are three types of expenses that will need to be claimed over a number of years:

	Borrowing expenses incurred in acquiring finance (eg. loan application fees)
	Decline in value of depreciating assets
	Capital works deductions

Decline in value & capital works

Decline in value (previously called depreciation) of items purchased with the property, such as a hot water service and curtains, are claimable over a number of years. These items may be claimed to the extent of their market value at the time of purchase. If the values are not specified in the purchase contract it is often advisable to engage a quantity surveyor to determine the values. The quantity surveyor will also be able to assess the value of the buildings so any capital works entitlement (i.e. cost of building) can be claimed. The quantity surveyor’s fee is tax deductible.

The cost of depreciable assets (such as carpet) purchased after the rental property was acquired can be determined from the purchase receipt. Saward Dawson will calculate the decline in value following the relevant provisions.

Interest expense deduction

Interest on funds used solely to acquire a rental property can generally be claimed as a deduction. Where a loan is used for both income producing and private purposes, the interest must be apportioned. Similarly, where a loan is partly repaid, a subsequent re-draw of funds will only give rise to a tax deduction for the additional interest if the re-drawn funds are also used for producing income. We recommend separating private and investment loans and treating them accordingly.

For example, a taxpayer borrows $150,000 to buy a rental property. Over time the loan is reduced to $100,000. The taxpayer then re-draws $20,000 for an overseas holiday. Interest on the $20,000 portion of the loan is not deductible. It is the purpose for which the funds are borrowed that is considered, not the security for the loan. However, if the money had been used to finance renovations to the rental property, the interest would be deductible.

Similarly, a couple may fully own their existing family home. They then decide to buy a new home and rent out their existing home. They use the first house as security for the loan to purchase their new home. In this circumstance, no interest can be claimed as a deduction against the rental income even though the funds are borrowed against what is now a rental property. The purpose of the new borrowing is to buy a private residence, not an income producing property.

For interest to be deductible, the loan should relate to the acquisition of a property that is intended to ultimately derive positive income returns. Loans on rental properties are often of such a size that the property is negatively geared. However, over time the Australian Taxation Office expects the loan and the interest deduction will reduce, resulting in a positive rental return. Taxpayers who regularly finance properties with long term interest-only loans, or who sell their properties once they commence returning positive rental returns, run the risk that the Australian Taxation Office may seek to disallow part of the interest claim. The Australian Taxation Office’s position is that in these cases the purpose of the borrowings is not to generate income, but rather capital gains. As such the negatively geared component of the interest may be disallowed. Obviously intentions can change, and the fact that one property never provides a positive return is unlikely to jeopardise your interest claim. However a history of negative returns may raise concerns with the Australian Taxation Office during an audit.

Split loans

Court cases have further put into question the deductibility of interest on split loans, especially where the interest on the investment portion of the loan is capitalised due to the arrangement of linking it to a private loan. If you have a split loan or similar please contact us to further discuss the implications. This will allow us to advise you on the most appropriate action to take.

Low doc loans

Low doc loans or low document loans continue to come under the spotlight of the Australian Taxation Office. These loans do not require income tax returns to prove income. As a result the lending institution usually charges a higher rate of interest. The Australian Taxation Office has audited a number of taxpayers who have low doc loans but have failed to lodge tax returns, or who have disclosed to their lenders income that is substantially higher than that disclosed in their tax returns.

Care must be taken to ensure reasonable income levels are disclosed when acquiring a low doc loan. Saward Dawson can advise you on the suitability of existing loans. We can also help you obtain loans that are both tax effective and appropriate for your cashflow position.

Property ownership

If a property is purchased in joint names each person is deemed to have an equal share in the property, and income and expenses must therefore be allocated accordingly. If income and expenses are to be allocated in any other manner the owners are regarded as “tenants in common”. This requires a specific legal agreement to be drawn up at the time of purchase.

Renting to friends or family

If an arrangement is made between friends or family members where rent is charged at below market value, the Australian Taxation Office may restrict the claims available to the extent of the rental income. The Taxation Office may accept an arrangement where the tenants agree to a below-market rental in return for maintaining the property.

Capital gains tax implications

If you acquired your rental property after 19 September 1985, capital gains tax will apply when you dispose of the property. The costs of buying and selling your property can be taken into account when calculating any capital gain or loss. These costs include conveyancing, advertising, legal fees, valuation fees and real estate agents’ commissions.

If the rental property was occupied as your main residence for a period, the capital gain on sale of the property may be reduced depending on the duration of your occupancy.

Published : 6 July 2007