Residential Property Investors look at ways to reduce tax payable in the same way as they shop around for loans to reduce the interest they pay; and use ways to defer paying tax just as they find ways to patch up to defer major repairs.

The Taxman looks at ways of collecting tax from Residential Property Investors at each stage of a rental property transaction, as follows:

Buying a rental property – stamp duty, tax treatment of purchase costs
Owning a rental property – income tax on rents, tax deductions, land tax, depreciation,
Selling a rental property – capital gains tax, tax treatment of sale costs

The Australian Tax Office would like to become the landlord’s friend. The ATO’s Rental Properties Guide gives advice to landlords on how to treat residential rental property items. This article draws on advice from the ATO Guide, and adds practical comments on the taxes payable on residential rental properties.

It is assumed that the rental property investment is not a rental property business or enterprise, otherwise different rules apply. The rental property is assumed to be in Australia.

Buying a rental property

Stamp Duty is a purchase tax. It is payable on Contracts for Sale / Offer and Acceptance Agreements and on Transfers of title. Stamp duty was first imposed in 1694 in England to finance the Nine Years’ War against France. It was so successful that it remains a major source of revenue for States and Territories in Australia today.

After the purchase price is paid under a Contract, the Transfer of title needs to be registered to complete the conveyance. Stamp duty cannot be avoided because the Land Titles Office will not register the Transfer of title for a property unless it is stamped.

Purchasers are responsible to pay stamp duty. In most States, stamp duty / transfer duty is payable in a set number of days after the date the Contract is entered into – it is 30 days in Qld & WA, 60 days in SA & NT, 90 days in ACT and 3 months in NSW. In Vic it is payable 1 month after the price is paid, in Tas, 3 months afterwards. Interest is payable if stamp duty is paid late.

In practice, stamp duty is paid not later than the date the purchase price is paid, so that the Transfer of title is registered. The stamp duty rate increases as the price goes higher. For example on a $300,000 price, it is around $10,000; on a $600,000 price, it is around $22,500.

What are known as related party transfers, such as a transfer to a family trust, or to an SMSF, or to a joint owner, are liable for stamp duty based on a market valuation by a property valuer. The main exceptions are transfers made under Family Law Orders or to a beneficiary under a bare trust or as an inheritance under a will, all of which are free from stamp duty.

Purchase costs are treated as capital outlays in the same way as the price. The Australian Accounting Standards Board Standard 140 on Investment Property states – An investment property shall be measured initially at its cost. Transaction costs [legal fees, transfer taxes, etc.] shall be included in the initial measurement. (paragraphs 20 & 21)

Therefore, purchase costs such as stamp duty, conveyancing fees, pest and building inspection and survey fees are capital costs which are added to the price to form part of the cost base for capital gains tax calculations. They are not expensed or deductible for tax purposes.

Repairs carried out immediately after the purchase are also capital costs, even though they are repairs, because the price paid reflects the state of repair of the investment property.

Borrowing expenses for the purchase are able to be written off / amortised over 5 years.

Residential properties are free from GST (Goods and Services Tax) when transferred, except for new residential properties where GST is paid by the seller out of the price.

Owning a rental property

Rental property profits (positive cash flow) are taxable as income. Rental property losses (negative gearing) are able to be offset against other income for income tax purposes.

Income tax was first imposed in Australia in 1915 to finance the Great War – World War 1. Today, personal income tax represents almost 50% of Australian Government revenue.

Rental Income is taxable as income when it is received by the landlord or by their rental manager. Rental Bonds are taxable as income when they are drawn down when the tenant defaults. Loss of rent insurance claims are taxable as income when received.

Rent is shared according to ownership shares for jointly owned properties. For tax purposes, a joint tenancy is the same as tenants in common in equal shares, in that each owner includes a one half share of the rental income and expenses in their tax return.

Are joint owners able to agree to divide property profits and losses in different proportions to their ownership? The answer is no - the legal ownership shares on the title deed override the owners’ agreement.

The inflexibility of ownership in personal names when it comes to dividing property profits is one reason why purchasing an investment property in a family trust is often preferred. Choosing the best name or entity to purchase a property is important because changing a name or share afterwards creates a stamp duty and a capital gains tax liability.

Loan interest is tax deductible as a property expense so long as the loan is used for the purchase, building or renovation of an investment property.

The loan purpose is important. Some property owners who move to a new home think about keeping their former home as a rental property investment. They plan to take out a new loan against the former home to pay for the new home, and then to claim the loan interest as a tax deduction. This plan does not work because the loan purpose is to buy a new home - a private purpose, not an investment purpose, and so the loan interest is not deductible.

Loan interest is only deductible while the property is available for rent. Therefore if a property owner stays in their holiday home, loan interest is not deductible during their stay.

One way to defer tax until the next tax year, is to bring forward property expenses. This is done by pre-paying expenses up to 12 months in advance. To pre-pay loan interest, an arrangement is needed with the lender, because otherwise the lender will receive the payment as a principal reduction. Strata levies and insurance premiums are often pre-paid.

If the loan is refinanced, or a new loan is taken out, the interest paid is tax deductible so long as the loan and the property are used for investment purposes. The borrowing expenses are amortised over 5 years, if greater than $100. Below $100, they are written off.

Repairs and maintenance to a rental property to make it rentable or re-rentable, such as replastering holes in a wall, repainting, replacing broken light fittings, fixing doors and locks, caused by tenant wear and tear are tax deductible.

Replacement costs for a stove, kitchen cupboards, carpets, hot-water system in a rental property are capital expenses, and are depreciable items, unless the cost is $300 or less.

Travelling expenses to inspect the property, and to do work, can be tax deductible, along with accommodation expenses. Limits apply where the inspection is incidental to a holiday.

Property outgoings - council rates, water rates, insurance premiums, strata levies are tax deductible while the property is rented or is available for rent. Special purpose fund strata levies for particular capital works are not tax deductible.

Property management fees, advertising and tenant default expenses are tax deductible.

Land Tax was first imposed in its current form in 1692 in England to finance the Nine Years’ War against France. It is a property tax assessed on the value of the land, excluding the improvements.

Land Tax is levied in all States and Territories in Australia and raises billions of dollars.

Land tax payable is calculated at up to 2.25% of the land value, the rate increasing according to ‘value’ bands. Land tax is payable annually on land held at midnight on 31 December in a year. It is tax deductible.

Depreciation is a measure used by valuers to calculate how long it normally takes for an asset to reduce in value and needs to be replaced. This length of time is called a useful life / effective life.

For example: carpet, lino and vinyl – 10 years; gas and electric hot water systems – 12 years; light fittings – 5 years; window blinds – 10 years; stoves, cook tops and range hoods – 12 years; dishwashers, washing machines and clothes dryers – 10 years.

Depreciation can be expensed for tax purposes using either the prime cost or diminishing value methods. If the acquisition cost or depreciated value is $300 or less, the cost can be written off.

Capital works deductions are available for capital works. Capital works are a structural addition or improvement such as a room, garage, patio or pergola; a structural alteration such as adding or removing a wall; or a whole building construction including walls, windows, ceilings, floors, fences, and stairs. The cost base for the capital works deduction is the construction cost.

The current tax law allows capital works deductions over 40 years, at the rate of 2.5% per year.

In most off the plan purchases, the property developer will provide a depreciation schedule prepared by a quantity surveyor for the purchaser to use to calculate the capital works deduction. The capital works deduction can be used by subsequent owners.

But there is a ‘sting in the tail’. The capital works deduction reduces the cost base for capital gains tax purposes. Therefore the capital gain is greater when the property is sold.

Selling a rental property

Sale costs such as selling commission, advertising and legal fees, are not expensed for tax purposes because they are capital expenses. On sale, mortgage discharge expenses are deductible and often the residual value of depreciated items is written off for tax purposes.

Capital Gains Tax was first imposed in Australia on 19 September 1985, as a trade-off to lower the high marginal tax rates of income tax
(the top rate was 60¢ in the $1).

Capital gains tax is only payable on sale of a property – it is not payable on annual increases in value. Therefore, if a property owner does not want to pay capital gains tax – they don’t sell!

And when selling, a property investor waits for one year after purchasing to halve the tax and sells after 30 June in a year to defer the capital gains tax payable for a year.

The tax is calculated on the profit on sale. The profit is the sale price, less the sale expenses, less the purchase price, less the purchase expenses such as stamp duty and legal fees, and less the cost base, as adjusted for capital works done and deductions while the property was owned.

The profit is then added as income into the income tax return of the seller. The full amount is added if the sale is within 12 months of the purchase, and one half is added if the sale is more than 12 months after the purchase. A property is treated as sold or purchased for capital gains tax purposes on the day that the Contract for Sale becomes unconditional.

Records for tax deductions need to be kept at least 5 years after the tax return is lodged. Records for capital gains tax purposes should be kept until 5 years after the property is sold.

Conclusion

There are practically no tax deductions available on the purchase of rental property. While the rental property is owned, a range of tax deductions are available for property expenses and for depreciation, to offset the rental income. On sale of the rental property, capital gains tax is payable.

Finally, residential property investors should support anti-war movements, because most property taxes originated from a need to finance a war, and the taxes are never repealed when the war ends!

The Landlord’s Guide to Renting has been produced by Cordato Partners Lawyers, as part of its Property Law practice. It contains a brief outline of the Tenancy Law.

Because it is a general guide, is not intended to be relied upon for any specific tenancy situation. For those situations professional advice should be obtained.

If you would like to receive the Guide as a pdf email attachment rather than as a hard copy, or would like further hard copies of the Guide to distribute to clients, friends and relatives -
Contact us by email – info@propertyinvestmentlawyer.com.au or by phone (02) 8297 5600 (speak to Sally Wade). Our office is located at Level 5, 49 York Street, Sydney NSW 2000 (near Wynyard Station).

Also visit our website – www.propertyinvestmentlawyer.com.au to view the Guide and other property investment information.

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