The tax benefits of owning an investment property are significant, but there are downsides for those who don’t know what they’re doing. So how exactly does our tax system treat real estate investors?

Understand the basics

When you own property and rent it out, the rental income you earn is taxable. However, you can then deduct any expenses you incur to generate that income.

Generally speaking, when your expenses exceed your income (i.e. you make a loss), your property is trending negatively. When your income exceeds your expenses (i.e. you make a profit), your property is described as positively oriented.

How deductions work

Of the various expense items you might incur to manage a rental property, probably the biggest is the amount you are paying on your mortgage. The interest element of your mortgage repayment is deductible for tax purposes. Therefore, by matching your property to the maximum level possible under the rules allowed by your bank, you can also maximize the interest charges that you can claim as a tax deduction.

In a common negative gearing scenario, the amounts you earn in rent are less than the amounts you spend on your rental property, including mortgage interest and any other expenses you can claim a tax deduction for, such as:

  • land rates
  • water tariffs
  • estate agent fees
  • advertising for tenants
  • pest control fees
  • Insurance
  • gardening and lawn mowing
  • depreciation on the cost of construction (for houses built after 1985)
  • repair and maintenance costs
  • legal entity fees
  • cleaning fee

This means that you have suffered a loss on your rental property and the tax legislation allows you to deduct this loss from your other income for the year. When you file your tax return, the resulting loss often results in a large tax refund.

Get your tax right

In addition to the obvious deductions listed above, you may not know that you can claim the following:

  • Expenses paid in advance. If you pay an expense this year that relates in whole or in part to next year, you can claim a deduction for the full amount this year. This is especially useful for expenses that straddle the tax year like insurance policies or subscriptions.
  • If you use your home phone, computer or internet services, or mobile phone, in the management of your investment property, you can claim an appropriate tax deduction

And some tips to avoid problems with the ATO:

  • Generally, repair and maintenance costs are tax deductible, but be very careful if you are claiming costs related to a problem that occurred before the property was purchased. The ATO often seeks to disallow instant deductions in this scenario on the grounds that these “repairs” are often capital in nature, being repairs made to rectify defects that existed when the property was acquired.
  • In order to claim deductions, you must rent the property on a commercial basis. If the property is rented rent-free (or at a non-commercial rate) to, for example, friends or family, the amount of deductions you can claim will be limited to the amount of rental income you have earned.
  • Always keep detailed records of all income and expenses. If the ATO reviews or audits your tax return, you will need your supporting documents to support your deduction claims. Normally, you must keep records for five years from the date you file your tax return, but for capital gains tax purposes (see below), you must keep records. buying and selling (along with details of any capital improvements) for at least five years. from the date of filing the statement of disposition of the property. Since you can retain ownership of the property for a long time, this means that your purchase documents, in particular, will need to be kept safe for many years.

Capital gains on investment properties

When you sell the property, you are subject to capital gains tax (CGT) on the profit. In very simple terms, profit is the difference between the proceeds of the sale (less selling costs such as legal and estate agency fees) and what you paid (including stamp duty and other administrative costs). purchase such as legal fees). CGT is levied at your marginal tax rate (between 19% and 45%) on the resulting profit. But, if you have owned the property for more than 12 months, you become eligible for the 50% CGT discount. This halves the amount subject to tax and is equivalent to halving the rate of tax you pay on the total gain.

Example: John buys an investment property in Sydney for $500,000 in 2010. He sells the property in 2022 for $1,000,000. Excluding buying and selling costs, he realized a capital gain of $500,000. Because he has owned the property for more than 12 months, he is eligible for the 50% CGT reduction, which reduces his taxable gain to $250,000. He pays tax on this figure at his marginal rate.

So back to negative gearing…

Where people make money from negative gearing is on the potentially favorable interplay between continued losses on rental income and the profit that will hopefully come from disposing of the property.

In short, you make a series of small annual losses on your rental income (for which you get tax relief at your marginal rate) but ultimately you make a potentially large capital gain on the disposal (which is taxed at half rate, actually). The profit on disposal often outweighs the small cumulative losses on rental income. Overall, therefore, you have realized a positive total return on your investment.

But beware. Without careful planning, housing investments can go wrong. You should always take detailed tax advice before entering the world of real estate investing.

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