Investing in property is one of the most effective ways to build wealth and reduce your tax burden. Over the years, thousands of Australians have purchased investment properties and in turn, been eligible to claim tax benefits such as negative gearing and depreciation. This resource explains how you can reduce your tax burden by investing in property.
If you are paying thousands of dollars in income tax every year, then investing in property could be an effective way to reduce your tax burden. This is especially relevant for high income earners or people who are progressing rapidly in their careers and find that more and more of their income is going towards tax payments each year.
The two major tax benefits that all Australian property investors can claim are depreciation and negative gearing.
Although depreciation is an important component of a property’s profitability, it can often be overlooked, meaning you could be losing thousands of dollars in potential tax deductions.
As investment properties get older and the items within them suffer wear and tear, they decline in value. The Australian Taxation Office (ATO) recognises this and allows investors to claim this loss of value as a tax deduction against their assessable income. This is called depreciation of investment property.
Just as you would deduct interest payments and the costs of maintaining an investment property, you are allowed to deduct the depreciating value of the property itself and the items within it. Investment property depreciation is known as a ‘non cash deduction’ because it doesn’t require any ongoing payments such as interest. The deductions are built in with your investment property – so if you don’t claim depreciation in your tax return, you are missing out on a genuine entitlement. It’s your job to claim it, and the ATO does not issue reminders.
The major benefit of depreciation is improving cash flow by reducing taxable income. Depreciation of an investment property itself is not necessarily a reason to invest in a property, but when claimed correctly it can make your property investment easier to manage and free up cash for further investment opportunities, thus helping you to build up your portfolio faster.
There are two major components of an investment property depreciation calculation – the Capital Works Allowance and the Depreciating Assets within the property. The ATO also refers to these respectively as Division 43 and Division 40.
The Capital Works (Division 43) allowance is the deduction available for the building’s structure, along with fixed assets such as built in cupboards. Essentially, this is anything that is a permanent fixture or cannot be removed easily from the property. This allowance is determined by the age of the assets and the type of construction. The ATO also has a comprehensive list of fixed assets on their website that qualify for the Capital Works Allowance. When working out the construction cost of a building or other capital works, you must use the actual or historical construction cost. This is not the same as the purchase price of the building, or even the insured cost or replacement cost.
Depreciating Assets (Division 40) are items commonly referred to as ‘plant and equipment’, or ‘plant and articles’. Loosely these assets are any item that can be picked up or easily removed from an investment property, such as curtains and hot water systems. The ATO gives Depreciating Assets an ‘Effective Life’ to determine how many years investors can depreciate them for. The ATO says the Effective Life has regard for reasonable wear and tear, and is estimated to be the time taken from purchase (not from the time you start using it in your investment property), until the item is likely to be sold for no more than scrap value. The rules about Effective Life provide flexibility for investors to maximise their depreciation allowance in the short term when renovating an investment property. For example, although there are aesthetic reasons to choose a certain type of floor covering, the more important consideration may be how much of a deduction for depreciation of investment property is allowable in the short term.
Australia is one of the few countries where negative gearing is an option. Negative gearing is based on a person borrowing funds from the bank to purchase a property which they can then rent out. Income from the rent will usually be less than the interest paid on the mortgage combined with the cost involved in owning a property. As this setup is working at a loss, it attracts tax benefits. Negative gearing is a strategy commonly used by people for this reason in an effort to reduce their annual tax payments. So in effect, the Australian tax office helps you own and pay for your investment property.
Negative gearing is regarded by many people as the ultimate goal in property investment finance, but this is not necessarily the case for everyone.
Not all investment properties are negatively geared. If your investment property earns more in rent than the overall cost of the finance, it is positively geared – and you will need to pay tax on the difference. This is not necessarily a bad thing – it depends on your financial situation, how much cash flow you require and how much the property gains in capital growth before you sell it. If you are unsure, it is always beneficial to seek professional advice on matters relating to tax.
Most properties, however, will be negatively geared, because the cost of servicing a loan is usually greater than the rent received.
Other tax tips
You can also benefit by using equity in your existing assets to borrow money and purchase another investment property. By looking at the bigger picture, you may be able to expand your portfolio and create wealth, all while further reducing your taxable income.
When tossing up whether you are going to purchase a brand new investment property or a second hand property, it always pays to purchase new. This will ensure you can claim full depreciation benefits.
Also remember, tax and investment property claims are not just related to the property itself. All costs incurred to inspect your investment property are tax deductible, including travel related expenses. This is an easy tax reduction tip that is often overlooked.
Always make sure you keep good records and receipts to substantiate any claims or deductions with the ATO. This will help you maximise your tax benefits and ensure you are getting the most out of your investment property.
Want to learn more? Contact the team of Perth Property Investment Specialists at Investor Assist today or download our FREE 9-Step Guide to Property Investment Success to help get you started.