Make sure your deductions are properly claimed, writes John Collett.
When it comes to claiming deductions, the Tax Office finds many landlords get it wrong because they don’t know better.
The single biggest deduction for most people who have borrowed to invest is the mortgage-interest costs.
That’s no problem, as the interest costs will be given on the lender’s statement to the investor.
But a common mistake made by landlords is to claim the interest costs for the whole 12 months when the investor has used the property for some of the year, says a tax partner with Sydney accountants and advisers HLB Mann Judd, Peter Bembrick.
The costs being deducted must be apportioned for the time the property was rented or was available for rent, he says.
Often, landlords are not aware that they can claim the costs of borrowing to buy the investment property, Bembrick says.
The rules say the investor is allowed to claim 20 per cent of the borrowing expenses for each of the first five years after buying the property (or over the term of the loan in the unlikely event that it’s less than five years).
Bembrick says the borrowing costs include the legal expenses and stamp duty on the mortgage but not the legal expenses or stamp duty on the transfer of the property.
Investors can also be confused by the concept of ”initial repairs”, Bembrick says. This is where repairs are made to the property immediately after buying it. ”But landlords are not able to get a deduction for that, even though they are repairs and not improvements, because the deterioration did not happen while the investor owned the property,” he says. ”That is a big trap because the investor may have plans to spend on repairs thinking the costs of the repairs are deductible.”
It may be better to do the repairs spread over time so that more of the expenses can be claimed, he says.
Another big area of confusion among landlords is about what is a repair and what is an improvement or replacement of an asset.
Repairs include ”restoring something to a working condition”, according to the ATO. Bembrick uses the example of a hot-water system because it is something that often needs to be repaired or replaced by landlords. The costs of paying the plumber and replacement parts can be deducted from the investor’s assessable income because it is a repair.
However, if the whole hot-water system is replaced, Bembrick says, the ATO would most likely view that as a replacement of the ”entire asset” and, like an improvement, it can be depreciated over time as per the ATO schedule of depreciable assets.
Improvements such as renovating the bathroom are capital costs, which cannot be claimed as a deduction but depreciated.
The Tax Office has an excellent guide called Rental Properties 2011, which can be downloaded from its website.
Among other things, it lists about 300 items and the depreciation they attract, and the ”life” over which depreciation can be claimed.
CAPITAL GAINS TAX
When investors sell an investment property, they may be liable to pay capital gains tax.
Capital gains tax applies to the difference between the ”cost base” (costs of ownership) and what the investor receives for the property.
If a property has been held for more than 12 months, the investor may be able to reduce the capital gain on which capital gains tax is paid by the 50 per cent discount.
The Tax Office says that if the investor transfers the property into someone else’s name, the investor may still have to pay capital gains tax.
Any capital losses can be used to offset capital gains.
Whereas tax on capital gains must be paid in the year in which the gains are realised, capital losses can be carried forward indefinitely to be used to offset future capital gains.
Prepaying interest could be beneficial
Some investment-property loans allow investors to prepay interest 12 months ahead. The investor can then claim the interest on money borrowed in the current tax year.
Peter Bembrick says the advantages of prepaying may be fairly marginal for most investors but it depends on individual circumstances.
”It really comes down to whether you can use the deduction more this year than next year,” Bembrick says.
If an investor expects to realise capital gains this tax year, they may prepay their interest on their property investment loan to help reduce their tax bill.
Also, tax rates for earnings less than $80,000 a year will effectively fall from July 1 this year, as part of the government’s compensation for the carbon tax.
The tax-free threshold will more than triple from $6000 to $18,200, while the low-income tax offset is to be reduced.
These investors could benefit by prepaying and claiming a bigger tax deduction this year than they will be able to get next year.
While there may be some tax savings in claiming interest this year for those earning less than $80,000, the investor nevertheless still has to have the money available to prepay the interest – funds that could otherwise be invested and earning income, Bembrick says.