The Australian Taxation Office (ATO) regularly identifies incorrect claims for investment property deductions and has placed particular focus in this area in recent times.
These stem from countless investment property owners simply not understanding how to properly claim those deductions.
When someone borrows to invest in property, the interest on the loan will generally be deductible to the extent it relates to investment purposes and the interest is charged at commercial rates.
Having a bank loan with the investment property used as security does not in itself mean that the loan interest is deductible.
The loan must be used for income producing purposes to ensure that this is the case.
Buying a property comes with associated costs such as bank charges, loan application fees and conveyancing.
The ATO allows these costs to be claimed evenly for the first five years after buying the property or over the term of the loan, whichever is less.
Repairs and maintenance
This expenditure must be carefully documented and be carried out to restore something to a working condition, rather than an improvement or a replacement.
For example, the cost of a plumber to unblock a toilet would be restoring that toilet to its original use and that cost would be deductible.
There would be a different tax treatment if that toilet was completely replaced with a new unit.
When an investor first acquires a property and does work on that property at the time of purchase, it could be considered an initial repair.
Those costs might simply be added to the cost of the property as a second element cost (costs associated with getting the asset into a condition for use).
It may be more practical to spread the repairs over time to obtain the deduction.
Capital works and depreciation
The distinction between a repair and a replacement can sometimes be unclear.
In the case of a replacement of a whole asset, the cost is depreciated over the time of the deemed useful life of the asset rather than claiming it outright.
Capital works deductions are generally made up of construction costs, cost of altering a building and cost of capital improvements.
An annual deduction at the rate of 2.5 per cent (4 per cent in certain circumstances) is generally claimed for capital works.
Capital works expenses form part of the cost base of the property and should be taken into account for capital gains tax (CGT) purposes when selling the property.
When an investment property is sold, CGT might be applicable.
A capital gain is the difference between the cost base (i.e. cost of the property with associated purchasing costs) and what the property was sold for (less any selling costs).
From a tax standpoint, when calculating the CGT, selling expenses such as advertising and commission are deducted from the sale price and initial buying costs such as stamp duty are added to the cost base.
If the property sold was held in an individual’s name or in a trust for 12 months or more, the taxpayer may be able to discount the capital gain by 50 per cent.
The tax on capital gains must generally be paid in the year in which the sale contract is entered into, but capital losses are carried forward indefinitely to be offset against future capital gains, i.e. that cannot be offset against general income.
Property acquired before September 20, 1985 is not subject to CGT.
Some lenders will allow borrowers to prepay interest for up to 12 months in advance.
This could allow the taxpayer to claim the prepaid interest in the year it is paid, rather that the year to which it relates.
For example, if a person was made redundant in July 2019 by his employer and received a large redundancy payment in August 2019, the redundancy payment would elevate a person into the top tax bracket for the 2020 income year.
The person could take advantage of the fact that a bank allows you to prepay interest for 12 months in advance, and then if that interest is paid in the 2020 income year, instead of the 2021 income year, he would benefit because he is in the top tax bracket that year.
Apportioning deductions between investment and private
In circumstances where the property was used for part of the year for private purposes, not all the rental expenses are deductible and need to be apportioned.
You will need to apportion the expenses if only part of your property is used to earn rent, such as a granny flat behind the family home, when you rent your property at non-commercial rates or if the property is available for rent for only part of the year, and in those circumstances you can claim expenses for the part of the year the property is being available for rent even if it is not actually being rented out.
In some circumstances, it may be easy to decide which expenditure is private in nature.
For example, interest expense for a full year would need to be apportioned based on the number of days of private usage throughout the year.
In other circumstances where you are not able to specifically identify the direct cost, your expenses will need to be apportioned on a reasonable basis.
In recent years, the ATO has taken a closer look at Victorian taxpayers with rental properties along the Victorian coastline.
It is not uncommon for the owners to use these properties for private purposes at times during year, in particular during summer.
Owners need to be careful that when they do use the property for private purposes, the correct apportionment is made between deductible and non-deductible expenses.
Owners should keep records of when the property is not used for investment purposes so that they can substantiate their expenses if they come under ATO scrutiny.
The ATO will unlikely accept investment deductions on an investment property that is untenanted and there is no effort being made to attract a tenant.
To be able to claim deductions when untenanted, the property must be made available for rent at that time.
This would generally be supported by a current advertisement for the property.
There is an onus of proof on the taxpayer to prove it was available for rent at that period.
Property investment is common and diligence is required to ensure records are kept up to date and deductions are appropriately claimed.
The ATO can take a strict approach to taxpayers incorrectly claiming rental property deductions or under-declaring capital gains.
Knowing what you can and cannot claim will help to ensure your return is prepared correctly.
Benny Berkowitz is a director at Chi Berkowitz Partners. The information provided is the opinion of the author. The AJN recommends that readers seek independent financial advice.