There has been a dramatic increase in the number of residential property owners in Australia, and their inexperience as landlords can cause them to make costly mistakes.
These mistakes are usually in the areas of financing, recognising tax obligations and opportunities, and set up arrangements, including how the property is held. Lack of financial understanding can also hold back people from buying an investment property, even when they can afford to do so.
It is imperative to consider the ownership structure before the investment is made as it can be very costly to transfer assets later.
When deciding on ownership of an investment property, factors such as asset protection, retirement and estate planning, financing, CGT when the property is sold, as well as ongoing tax issues, must be considered.
When properties are held jointly with another party the net rental income or loss must be split in the correct percentage according to ownership. This must be substantiated through appropriate records.
If a family company or trust is used to purchase the property, other issues arise. These include the different CGT rules, the relevant land tax rules and the effects of negative gearing. Compliance costs (both set-up and ongoing) must also be considered although there are often good reasons to hold investment properties in a separate vehicle such as a family trust.
How finance is arranged can be critical and investors must focus on the actual use of funds, regardless of the security they offer for the loan. It is an area that is commonly misunderstood.
Tax deductibility of the interest of a loan for purchase of a property is determined by the actual use of the money, not the security used – the security for the loan does not necessarily have to be the investment property itself, it could be the family home or other personal assets.
However, the tax ramifications must be considered if a redraw loan facility on the family home is going to be used to buy a new property to live in, so that the original home becomes a rental property, as any associated interest on the new borrowings may not be deductible.
On the other hand, for mortgages with an offset facility the ATO accepts that any excess funds could have been placed into the offset account and later withdrawn without reducing the balance of the original loan. The interest would be then be deductible on the original property now being rented. This arrangement needs to be in place from the beginning.
Nevertheless, depending on other considerations such as gearing it is usually best to use any available cash to buy a home and to pay for personal expenses, then use borrowed funds for investment properties. This maximises tax benefits.
As noted above, a common mistake is to make extra repayments on an investment loan, and then use any redraw facility to take out money for private purposes, meaning any interest attributable to the redrawn funds will become non-deductible.
Other tax deductions
In addition to interest payments, any costs associated with taking out a loan, such as loan establishment fee, cannot be claimed outright but must be claimed over the lesser of five years, or the term of the loan.
Any travel expenses for property inspections are also deductible if the main purpose of the trip is to visit the property. In some cases, landlords will need to apportion expenses if there is a private portion of the trip.
Depreciation vs capital works
The difference between depreciable assets and capital works needs to be understood. It can be a complex area to come to grips with.
For example, while a cook top, stove and dishwasher are depreciable, kitchen cupboards and sinks are not, and only eligible for the 2.5% building allowance.
Further, while most landlords are aware they can depreciate expenses such as carpets or curtains in their property, they can also depreciate property owned by the body corporate such as carpets in the common area.
Landlords who have lived in a property before it was rented, can also claim a CGT exemption in certain circumstances when they come to sell it, as long as they do not have another main residence during the same period.