There are two ways in which real estate can be subjected to Federal income-tax. These are 1) under ordinary income-tax principles for rented properties and 2) the Capital Gains tax.
Both contain many traps for the unwary. Let us look at each.
When a property is rented out, the gross rent received is taxable. All outgoings are allowable deductions. Typical deductions for a rented property are: Estate agent's management fees and letting fees and inspection fees and out-of-pocket expenses, bank charges, Body Corporate levies, depreciation, insurance, interest on mortgage loan, land-tax, lawn-mowing, legal fees re rent collection and lease preparation and mortgage preparation, postage and stationery, Council rates, water and sewerage rates, repairs, telephone, travel to collect rents and to inspect property. The foregoing are typical expenses. It must be emphasised that any outgoing incurred in earning the rent is an allowable deduction.
Depreciation is allowed on Plant or Articles. There are now only seven rates of depreciation. However, an individual tax-payer can exceed any one of these rates if he can justify the increase to the Taxation Office. Typical items depreciated for rental properties are: air-conditioners, 18%; carpets, 36%; curtains and drapes, 27%; general furniture and fittings, 13.5%; hot-water services, 9%; radios, 18%; fridges, 13.5%; stoves, 9%; TV sets, 18%; vacuum cleaners, 18%; washing machines, 27%.
Strictly speaking, it should not be possible to claim depreciation on fixtures and fittings for two reasons. The first reason is that they are not "Plant or Articles", as required by the Act. The second reason is that in rented premises, they do not belong to the lessee but belong to the landlord. Consequently, it is the landlord who should claim. Despite these two objections, the Tax Office in practice often allows claims for depreciation on fixtures and fittings.
Depreciation on buildings is now allowed. It is generally at 2.5% of cost price. However, in general, it is only building constructed after 1982 (or 1985, in some cases) that attract a depreciation deduction. The cost of the land is excluded from the depreciable amount.
It should be noted with regard to interest deduction that it is immaterial as to how the loan is secured. To obtain a deduction, the sole test is to what use the loan was put. If the loan was used to buy an income-producing property, the interest is deductible. Let us take an example. John Smith owns a rented property. He borrows $30,000 from the bank to buy a new car. The car is not used for business. He secures the loan by mortgage on his rented property. The interest is not deductible. The loan was used to buy a private car. The fact that it is secured on the rented property is immaterial.
"Negative gearing" has become a popular tax-saving device in recent years. Basically, negative gearing means borrowing money to buy an income-producing asset. The interest is tax-deductible. The usual net rate of return on a rental house is about 5% and on a rental unit is about 7%. This is after claiming all deductions including depreciation but not including mortgage interest as a deduction. In recent times, the interest rate payable on a loan would have been about 12%. One can see that if one borrows at 12% and gets a return of 7%, a loss will be sustained. The borrower hopes to cover this loss by a rise in the property value. The rental loss will be deductible from the tax-payer's other income.
Negative gearing is worth while if a) the tax-payer is in a high tax bracket for example with a taxable income in excess of $35,000 and b) the value of properties is going up. If the value of properties is static or going down, then negative gearing is not a good method of investing.
Heated disputes often arise with the Taxation Office over the deductibility of repairs. The tax-payer claims the deductions as repairs. The Taxation Office disallows them as improvements. Again, often a person buys a run-down property. He brings it up to an acceptable level of repair at considerable cost. He is astounded when the Taxation Office disallows the "repair" costs. To try to understand this, it is helpful to look at the economic rationale underlying the Taxation Office's actions. Simply put, if a person buys a property costing, say, $100,000, then any expenditure which maintains the value at $100,000 is deductible. Any expenditure which increase the value above $100,000 is non-deductible. Such expenditure obviously results in an improvement. Our example takes no account of inflation. Obviously, inflation will have to be taken into account. However, the Taxation Office, following case law, does not strictly adhere to this economic model. For example, the replacement of a dilapidated ceiling with a new and better ceiling will be treated as an improvement and not a repair. From what has been said, it is obvious that if a person buys a property costing $100,000 and then renovates it at a cost of $10,000 so that its value increases to $110,000, then the expenditure of $10,000 will be an improvement and not a repair. However, if the seller had incurred the $10,000 in renovations, then it would have been deductible to the seller as a repair. It is assumed that when the seller initially bought the property, it was worth at least $110,000. Consequently, as a general rule when buying a run-down property, one should negotiate with the seller to have the property renovated first. One can then negotiate a price for the renovated property.
After premises cease to be let, repairs to make good damage done by the tenants can be deducted provided the repairs are carried out reasonably soon after the tenants vacate.
However, as a general rule, any expenditure that is not allowed as a deduction for income-tax purposes will now be allowed as a deduction for capital gains tax.
CAPITAL GAINS TAX
Capital Gains tax was introduced on assets acquired after 19th September 1985. If a property was acquired before this date, no capital gains tax is payable on its sale.
The costs involved in acquiring an asset are deductible. For a property, this would involve legal fees, stamp duty, valuation fees etc. Likewise, the costs of disposing of an asset are deductible. For a property, this would include legal costs, stamp duty, estate agent's costs etc.
The full profit on the sale of an asset is not subjected to tax. The cost price is increased by the CPI index, thereby reducing the profit. The CPI index stood at 144.2 in September 1985 and at 217.1 at 30th June 1992.
If a property was bought before 19th September 1985 and a major improvement was made to the property after that date, then the improvement itself will be subject to capital gains tax. However, for the improvement to be taxable, the cost of the improvement must exceed $50,000. This $50,000 limit is CPI indexed every year from 1985 onwards. Currently, the limit stands at $78,160. Also, the profit on the sale of the improvement is not taxed if the indexed cost of the improvement does not exceed 5% of the overall sale price of the property. It should be noted that the date of sale for a property is not the date of the transfer but rather the date of the signing of the contract of sale.
The sole or principal residence of the tax-payer is exempt from capital gains. If, when a property is sold, it is found that the tax- payer had not lived in the residence during the whole of the period, then the profit is pro rata reduced. Suppose a tax-payer bought a house on 20th September 1985 and sold it on 20th September 1991 at a profit of $10,000. He had only lived in the house from 20th September 1985 to 20th September 1988, a period of three years. Only 3/6th of the $10,000 will be taxable.
There is a similar apportionment if the residence was used partly for business during the period. The period that it was used for business will count for capital gains. Letting the property counts as business use. However, the use of part of the property as a home-study or for paid child-minding does not count as business use. To count as business use, a part of the residence must be set aside exclusively as a place of business. An example is a doctor's surgery.
Land up to 2 hectares adjacent to a residence will form part of the residence and be exempt from capital gains tax.
If a tax-payer has two residences, he may nominate one only as his principal residence and thereby obtain tax exemption for it.
A windfall capital gain will not push you into an unduly high tax bracket. The reason for this is that the tax rate to be applied to the capital gain is ascertained by taking only 1/5th of the capital gain. For example, suppose the capital gain is $10,000 and other taxable income is $25,000. Take 1/5th of $10,000 which is $2,000. Add this $2,000 to the $25,000 income making $27,000. The tax rate applicable to $27,000 will be the rate applied to the whole capital gain of $10,000.
It should be noted that capital gains tax is not limited to profits made on the sale of Australian properties. An Australian resident will be subject to Australian capital gains tax on any profits made from the sale of foreign properties. However, there is no double taxation of profits. The foreign tax paid, if any, will be offset against the Australian tax payable.
In any year, the profit made on one property may be offset against the loss made on another. However, a net capital loss cannot be deducted from other income. It can be carried forward indefinitely and deducted from any future capital gain.
From what has been said, it is obvious that if one wants to be free of capital gains tax, an obvious way to do it is to put one's money into one's residence. Australia-wide, people have in fact been doing this and acquiring palatial residences. The result has been that there has been much less money available to finance business enterprises. To remedy this situation, it is rumoured that the exemption for the principal residence will be abolished soon.
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