Before I start this post, I need to say that the information provided here, and on our site and blog overall, is general in nature only. It does not take into account your personal objectives, financial situation or needs. Before acting on this information you should consider the appropriateness of the information with regard to your own objectives, financial situation and needs – and most importantly, with the personalised advice of a properly licensed taxation practitioner.
So as always, please educate and inform yourself, but get professional taxation advice tailored to your situation before acting.
Okay, with that understood, let’s discuss some of the taxation aspects of property that you should understand.
Are you planning to grow your wealth in the future by investing in property
Property investment has long been embraced by Australians as a great way to build wealth and security, and one of the reasons for this is the structure of our tax system.
It’s important to know what you want out of your investment portfolio. Some of the things that investors might look for, depending on their individual circumstances are:
- $ Great cash flow or earning potential to supplement their income, or provide a passive income for their later years
- $ A range of properties achieving solid capital growth over time
- $ Properties attractive to potential tenants, likely to be tenanted with little fuss
- $ Properties offering significant tax benefits to offset a high income
- As an investor, your ultimate goal might be to build a property portfolio that pays for itself each month whilst growing in value. Regardless of your goals, managing an investment portfolio takes knowledge of both the real estate market, and the Australian tax system.
When you have the best possible structure for your investment portfolio, there are likely to be significant tax advantages. To aid you on this path to financial success, the following is a list of some of the things to think about when investing in residential property.
Negative gearing
One of the benefits of investing in property is that you can use any losses to reduce your taxable income. Often referred to as negative gearing — the idea is that the rental income you receive is less than the interest you pay on your loan, depreciation on the property and any maintenance and outgoings you pay throughout the year.
Negative gearing occurs when the income generated from an investment is less than the cost of owning and managing it.
Generally speaking negative gearing is just a stepping stone that helps you out in the early stages when you first own the investment. The goal is to have the best of both worlds where the rental income grows to exceed the costs of owning the property whilst the value of the property is also increasing.
Example: negative gearing
If you own an investment property where the rent received is less than:
- $ The interest you pay on your loan if you borrowed to purchase the property
- $ Maintenance expenses incurred for the property $ Depreciation of the property and assets
- $ Other costs associated with owning and managing the property
Negative gearing allows for a reduction in personal tax income because while investors are required to pay tax on income received from investment property, their taxable income can be offset against income from other sources.
What about my cash flow?
Cash flow is not the same as positive and negative gearing.
- $ ‘Cash flow positive’ means that the rental yield is higher than the interest and outgoings.
- $ ‘Cash flow negative’ means that the rental return is less than the cost of holding the property.
It’s possible to have a property that is cash flow positive, but negatively geared. This happens when depreciation is included, tipping the scales towards the negative and creating a tax deduction for the owner — even though in terms of real money there was no cost to hold the property that year.
Negative gearing can be beneficial because it is expected that your property will increase in value over time. Investing in residential properties is in this way an investment for the future, suitable for investors who like to think about their finances long-term.
Structuring your investments to allow for negative gearing may only have a minor tax benefit in the short-term, but could pay dividends when you decide to sell the property. Essentially, the tax benefit softens the blow of holding a negatively geared property by allowing you to claim the difference between income and costs as a deduction — reducing your overall taxable income.
Leveraging your investment
Leveraging occurs when you use a debt to finance an investment. For example, of you were to take out a loan to purchase an investment property, interest on the loan, along with the cost for maintaining the property (as mentioned above) can be compared with rental income, and thus will allow for a tax offset.
The great thing about diversifying your wealth by investing in residential properties is that when tax time comes along, there are many so many ways to offset your expenses. Some common deductions may include:
- $ Advertising for tenants $ Agent fees and commissions $ Bank fees
- $ Cleaning and gardening expenses $ Council rates and land taxes $ Building and landlord insurance $ Interest payments $ Legal expenses $ Repairs and maintenance costs $ Water charges
- $ Depreciation of fixtures and fittings in accordance with a depreciation schedule
- $ Depreciation on the building for certain properties
- $ Visits to the property to inspect the condition (although this can only be for the sole purpose of visiting the property — not a family holiday in disguise!)
Key Point: It should be noted that deductions can only be made for the period of time in which your property was rented or on the market for renting – so keep those receipts. The tax office’s mantra is “no receipt = no deduction”; so file everything, no matter how insignificant it seems at the time.
The ATO are increasing their audit activity and it is important that you are able to justify and back up every claim. Furthermore, these deductions are only applicable to the expenses incurred by you, the property owner, and does not extend the items paid by tenants under your roof.
Depreciation
The ATO allows for property investors to claim depreciation for the fixtures and fittings of a property, and sometimes the building itself — depending on the property. Depreciation is calculated by a process of writing-off sections of the assets’ value over the course of its estimated useful life.
Depending on the type of structure and when it was built, a property’s useful life ranges from 25 years to 40 years. In some specific instances this period may be shorter.
Some of the fixtures and fittings which might be depreciable are:
- $ Carpets
- $ Blinds and curtains $ Oven
- $ Dishwasher
- $ Air conditioner
- $ Heaters
- $ Hot water service
Key Point: A depreciation schedule is essential, and the best option is to engage a Quantity Surveyor to help you with this. Their fees are tax deductible, and their advice is invaluable to ensure you maximize any possible deductions that you are entitled to.
The ATO also provides a comprehensive guide for appropriate boundaries of depreciation calculations so you have a general understanding of what you’re dealing with, however it is also a great idea to speak with your accountant for complicated deductibles and expense claims.
Capital Gains Tax
Capital Gains Tax (CGT) is an important factor to consider when managing your residential investments and structuring your investment portfolio. A CGT event is any transaction or event that results in a capital gain upon the disposal of an asset.
The term ‘asset’ includes:
- $ Shares
- $ Vacant land
- $ Holiday homes
- $ Business premises
- $ Residential investment property
A capital gain (or loss) is the difference between the purchase price and selling price of a particular asset. The impact of CGT should not be understated. It should factored into the decision making process and the timing of selling your residential investment property; it may be more beneficial to sell up in one financial year opposed to another. Oftentimes, CGT is an unavoidable fact of life when you have a dynamic and evolving investment portfolio.
The best way to avoid paying capital gains tax is to not sell!
Generally you will be exempt from paying capital gains tax on your principal place of residence, but if you have used a property as a place of residence as well as investment rental property, you may be expected to pay capital gains tax for this period.
Speak with your accountant to get a better understanding of the impacts of CGT before you make any major decisions on your property investment journey.
Insurance
Insurance is a must for smart investors, and could be the difference between sleeping at night — or not.
At the very least, it’s vital to take out building insurance to protect your property in case of unforeseen circumstances — like a fire or major weather event. But if you choose only minimal insurance, keep in mind that your building insurance usually will not cover the costs of replacing carpets, curtains or other items which are classified as ‘contents’.
Landlords insurance is a great option to consider, and there are several products on the market which can protect you in case of:
- $ Damage by tenants
- $ Machinery breakdown of a major fixed appliance
- $ Legal liability in case of an injury or damage caused to a tenant or visitor to the property
- $ Tenants who default on the rent or vacate their lease
Key Point: Another great insurance policy in addition to this is to select the right Property Manager – someone who will be vigilant in screening and monitoring your tenants, ensuring your investment is in good hands.
Risks involved
Whilst investing in residential property can be a great option for those hoping to accumulate wealth over time, investment properties are a big commitment and it’s important to be aware of the risks involved.
The housing market is forever in a state of flux and there are sometimes other factors that influence the market which are largely out of your control. A potential pitfall of this style of investing is that it relies on the purchased property to increase in value over time, just as you would expect from the rest of your investment portfolio.
While you can usually count on prices to ever be increasing (it seems to be a fact of life that inflation and time are positively correlated and things will always be more expensive tomorrow), when it comes to property investment, you have a lot riding on this assumption.
If property prices were to decline, the potential tax implication is that your losses might exceed your profits from other sources resulting in a net loss. In the same way, if the property is vacant or you end up with tenants who do not pay rent on time (or at all); your financial situation could be in jeopardy.
When it comes to finances though: nothing ventured, nothing gained!
Investing in property can be a great way to gain and maintain wealth. It’s more accessible to inexperienced investors. While significant research should be done in visiting suburbs, open houses and auctions, you don’t need as much specialist knowledge as you would playing the stock market.
Furthermore, owning investment property gives you more control over your assets – you have a direct say in how the property can increase in value (though renovations and expansions), and the income cash flow (you can choose the tenants and the rent amount).
If you’re looking to invest in property, start with a clear plan and strategy, and draw on the knowledge of qualified experts such as accountants, financiers and quantity surveyors.
While it may seem a bit daunting to first time investors, there is plenty of information out there to help you get your finances looking the way you would like.
Smart property investment is an investment in your future.