Most investors will be familiar with rental properties, but many do not fully understand the rules and concessions available. In this article we look at the tax benefits and concessions that property owners are eligible to claim. There are two situations that need to be covered.
- Firstly, the tax tips and tax benefits associated with the holding of rental properties.
- The second relates to the concessions available on their sale.
- Holding an investment property – The tax concessions
These fall into two broad areas. The first is the negative gearing aspect. This is where the holding costs exceed the rental income. The second is the non-cash effect of depreciation claims, both of which have a very positive effect on the tax you pay.
Example – Negative gearing
If your annual rent from your property is $25,000 p.a. and during the year, you incur interest costs, rates, body corporate fees and some repairs that total, $27,000. Your net cash loss is $2000 p.a.
If you purchased a new or relatively new property, you could expect to claim depreciation write-offs. Let’s assume this is about $8000. Now your loss for tax purposes is $10,000. If you are at the top marginal tax bracket, this will give rise to a tax refund of $4700.
The tax refund has more than paid the cash flow shortfall. This formula holds true for all rental properties held. Hence, you can see why professionals such as doctors, lawyers and even accountants own multiple properties.
They are using their rental properties to reduce their current tax and build wealth for the future. Of course, wealth is only built when the properties go up in value.
Capital Gain or Increases in Income
Assume, in a particular year, that you have a large capital gain or a large income for some reason that may not reoccur. This gain (and the tax associated with it) can be offset or eliminated by simply prepaying one year’s interest on one of your property loans.
Before 30 June, you borrow and pay in advance the next year’s interest on a loan associated with your income-earning properties. This will be deductible in the year it is paid. Your tax bill can be reduced accordingly.
Note: The rule is that a tax deduction is based on what the money is used for, rather than the security used to obtain the loan.
- 2. Tax Concessions on the Sale of Rental Property – 12 month holding rules
The ATO allows a 50 per cent CGT exemption for any gains made on the sale of a rental property held for more than 12 months. This holding rule time period applies from the date after the contract is signed and runs to the date after the contract of sale. The 12 months excludes the date of purchase and date of sale.
We have seen many cases where the client thought the settlement dates for the purchase and sale were used to ascertain whether the property was held for 12 months. While this may sound logical, as ownership is based on settlement, this is not the case from a tax perspective. If you have not held a rental property for in excess of 12 months, you do not get the 50 per cent CGT discount.
Example of tax payable
Sale price of property $750,000
Less agent’s commission and advertising costs $18,500
Less legal fees on the sale $2500
Net sale proceeds $729,000
Cost of property $500,000
Legal fees, stamp duty, etc. $35,000
Renovations and improvements $85,000
Total cost of property $620,000
Net profit $109,000
Less 50% CGT exemption $54,500
Taxable capital gain $54,500
You have made $109,000 in profit. Now comes the tricky part. From the above, we have a taxable capital gain (of $54,500) that is added to your taxable income and taxed at your marginal tax rates. The following various scenarios will apply to this gain.
If you plan your affairs, you should be able to choose the scenario that has the lowest tax option:
- If the property is owned in both your and your spouse’s name, then only $27,250 will be added to each of your taxable income for the year.
- If you limit your income in the year the gain is made, the marginal tax will be lower. For example, if $27,250 is the only income both yourself and your spouse will earn in a year, the tax will be $1720 × 2 = $3440. If the profit is earned by one person, the tax will be $8180.
- If you are operating your business (hence your other income) through a company, you may be able to do the above by simply reducing the salary you pay yourself in the year the capital gain is made – drawings can be treated as a complying division 7A loan.
- If the above property is owned by a company, which we will assume is not a base rate entity (as the income is passive rent income), then the tax payable will be at 30 per cent on $109,000, which is a total of $32,700. Companies do not get the 50 per cent CGT discount.
Tax Tip – This is a very important tax planning tip. Don’t own real estate in a company structure. If you own other assets that have unrealised capital losses, it may pay to realise those losses in the same year.
If you cannot achieve any of the above, tax will be payable at the top marginal rate of 45 per cent, plus the Medicare levy of 2 per cent, totalling 47 per cent. Hence, you pay tax of $25,615.
Again, by planning and being proactive, you can limit the tax payable on the above gain.
The main point is that you have made $109,000 on the above and will pay tax anywhere from $3440 to $25,615 (or $32,700 if owned in a company structure, which I never recommend). Your after-tax profit will range from $105,560 to $83,385.
Still a good result! The 50 per cent CGT exemption on rental properties is something many investors can benefit from. As a taxpayer, you need to ensure you meet all the conditions and apply this concession to reduce your tax.
How can we help?
If you have any questions or would like further information or you are seeking property tax advice, please feel free to contact our office via email –info@investplusaccounting.com.au or phone 02 9299 7000 to either speak with someone or arrange a time for a meeting so we can discuss your requirements in more detail. You can arrange a free 15 minute no obligation chat to discuss your options. Please arrange an appointment with our office by clicking here
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