As Perth is currently experiencing some of its lowest residential vacancy rates in almost 10 years, we thought the time was right to talk about rental properties and what you should know as a landlord, including:
- what you can and can’t claim as rental deductions;
- the difference between rent and board;
- negative gearing;
- why you must check your ABNs; and
- more Q&A responses.
If you are considering entering the investment property market and would like to talk to someone about structuring your affairs in the most tax effective way, please feel free to contact us and book a time to talk. As experienced accountants and tax agents, we can advise you on the pitfalls to avoid when making significant acquisitions and discuss the key considerations of equity, cash flow and asset protection.
Until next time,
Jody and the Team at Up-To-Date Accounting
Rental Property Expenses
What you can and can’t claim
It’s common for landlords – particularly new ones – to be confused about what they can and can’t claim as a deduction for their rental property. What often seems to make perfect sense in the real world is not always allowable according to Income Tax legislation and could get you into trouble with the Australian Taxation Office.
Your reportable rental income is the total of all rent and related payments you receive or become entitled to when you rent out your property. This is true whether it is paid to you directly or to a third-party like a real estate agent, and includes not only cash (monetary) payments but also payments made via goods or services. For example, if you allow a tenant to live in your rental property in exchange for repairs and maintenance labour (say, for example, your tenant is actively renovating your rental property for you), you would need to calculate the value of their services and declare that as rental income. You also need to declare any money held by way of a bond payment kept because a tenant has left your property in a state that requires cleaning, fumigation or repairs, or defaulted on paying rent, or if you receive an insurance payout covering lost rental income.
Not all landlords own properties either solely in their own names or as joint tenants with their partner or spouse. Some properties are owned by a number of people or entities and in varying percentages of ownership. In such cases, you as the taxpaying landlord must declare the full amount of the rent you are entitled to in your tax return. If that share happens to be 12.5%, for instance, then it is your responsibility to include 12.5% of all relevant rental income in your tax return.
In general, deductions can only be claimed if they were incurred in the period that you rented the property or during the period the property was genuinely available for rent. This means that a tenant needs to be in the property or that you would need to demonstrate that you are actively looking for a tenant for your associated deductions to be claimable.
If you keep your property vacant while you are renovating it, then you might not be able to claim the expenses during the renovation period if it was not rented or available for rent during this time (there are some exceptions to this general rule). There needs to be a nexus (connection) between the money you make and the deductions you claim.
Deductions You Can’t Claim
You can’t deduct costs incurred as a result of buying or selling your rental property (as they are Capital Gains Tax items and must be treated accordingly).
You can’t deduct expenses that you didn’t actually incur yourself. For example, you can’t claim the gas or electricity expenses paid by your tenants.
You can’t deduct expenses relating to a property or holiday home during periods where it was vacant and unavailable for rent.
From the 1st of July 2017, you are also no longer allowed to claim costs associating with travelling to inspect your rental property unless you are carrying on a business (more on that below), or if you are considered an excluded entity (a public unit trust, managed investment trust, etc).
There may well be other circumstances in which not all of your deductions are claimable. For instance, if you are renting your property out for less than commercial rates, or if your property is only available for rent for part of the year. You would therefore need to apportion your expenses accordingly.
Common Problems We See
Interest on bank loans
Only the interest on repayments for investment property loans, and bank charges, are deductible – not the actual loan (principal portion) itself. If a loan facility is used for multiple purposes, only some of the interest expense might be deductible. For example, if some of the loan is used to acquire or renovate a rental property but further funds are drawn down to pay for a holiday (a personal or private cost), then suddenly yours is considered a mixed purpose loan and a series of apportionments will need to be made to accurately calculate your deductible amounts. (Pro tip: don’t mix your loan purposes. It’s cheaper in terms of compliance costs to seek a new/alternative credit facility or save for whatever private purchase you are considering making. Keep any rental or business loans you have strictly for those specific purposes.)
Repair, maintenance or replacement?
Deductions claimed for repairs and maintenance is an area that the ATO continues to look closely at, so it’s important to understand the rules. An area of major confusion is the difference between repairs and maintenance, replacements and capital works. While repairs and maintenance can often be claimed immediately, the deduction for replacements or new capital works is generally spread over a number of years (the effective life of the asset).
Repairs must relate directly to the wear and tear resulting from the property being rented out. This generally involves restoring a worn out or broken part – for example, replacing damaged fence posts or fixing a broken toilet. The following expenses will not qualify as deductible repairs, but are capital expenses:
- the replacement of an entire asset like a complete fence, a new hot water system, or an oven, etc;
- improvements and extensions where you are going beyond the work that is required to restore the property back to its former state.
It is also important to remember that any repairs and maintenance undertaken to fix problems that existed at the time the property was purchased are not deductible, even if you didn’t find out about the problem until later.
The sharing economy
The deductions you can claim for “sharing” a room or an entire house are similar to rental properties. You can claim tax deductions for expenses such as the interest on your home loan, professional cleaning, council rates, insurance, and so on. But, these deductions need to be in proportion to how much and how long you rent out your home. For example, if you rent your home for two months of the financial year, then you can only claim up to 1/6th of expenses such as interest on your home loan as a deduction. This would need to be further reduced if you only rented out a specific portion of the home.
Friends, family and holiday homes
If you have a rental property in a known holiday location, the ATO is likely to be looking closely at what you are claiming. If you rent out your holiday home, you can only claim expenses for the property based on the time the property was rented out or genuinely available for rent and only if the property was not actually being used for private purposes at the time.
If you, friends or relatives use the property for free or at a reduced rent, it is unlikely to be genuinely available for rent and as a result, this may reduce the deductions available. It’s a tricky balance, particularly when you are only allowing friends or relatives to use the property in the down time when renting it out is unlikely.
A property is more likely to be considered unavailable for rent if it is not advertised widely, is located somewhere unappealing or difficult to access, and the rental conditions – price, no children clause, references for short terms stays, etc., – make it unappealing and uncompetitive.
Carrying on a business
The majority of rental properties owned by “mum and dad” landlords are for investment purposes. However, some people own and oversee a number of properties, equating to carrying on a business. Where this is true for you, you must apportion your rental income and expenses according to your partnership agreement or the applicable ownership or distribution percentages, if the business is conducted via a company or trust structure. In the event that you don’t have a partnership agreement in place, we recommend dividing your income and expenses between partners, equally.
While most taxpayers do the right thing, some attempt to over-inflate their deductions using receipts or invoices they have obtained for private, personal or work-related purposes. As a taxpayer, you are ultimately liable for the accuracy and completeness of the information included in your tax return and we therefore urge you to remain truthful and adhere to the law when considering what deductions to claim. If you find that you are ever in doubt as to whether or not an expense is deductible, please feel free to ask us.
Importantly, it is your responsibility as a taxpayer to maintain adequate records for the time periods required in order to meet the substantiation provisions of the Income Tax Assessment Act. For most deductions, this is a period of five years from the date your Income Tax Return is lodged, however, when there are capital gains tax assets involved, you will need to maintain your records for the entire period you hold the asset in question and then for a period of five years after the disposal has been documented in your Income Tax Return. Depending on the assets you personally hold and your investment style, this could be a very long time! We therefore encourage you to review your record keeping systems at least annually and make back up copies of important documents and transactions, which may in turn mean updating the software or products you use to maintain your records, as technology advances.
Rent or Board?
If you rent out all or part of your property to a friend or relative at a reduced rate, you will need to consider whether the revenue you are receiving is in fact rent or if it is considered board, and proceed accordingly. Where income is considered rental revenue and it is being charged at less than what would be charged to a third-party or arms-length tenant, then not all expenses incurred by you as a landlord will be deductible. You will have to apportion your expenses as appropriate.
Payments from a family member for board or lodging (for example, an adult child of the property owner) are considered to be domestic arrangements and are therefore not rental income. That means you can’t claim deductions for expenses associated with having that family member live in your property.
It may surprise you to know that you won’t find the term “negative gearing” in income tax legislation. While most commonly used in the context of owning a rental property, negative gearing can apply to any assets you hold in which the expenses incurred in owning the asset outweigh the income the assets accrue.
Assets are negatively geared when they are purchased with the help of borrowed funds and the net income, after the deduction of all associated expenses, is less than the interest charged on the loan. What that results in is a net loss which you can then offset against other earnings in that same financial year. In the rare event that you don’t have sufficient other income to offset this loss, you end up with a carried forward loss that is then factored into your next tax return.
While making a loss on an investment can seem counterintuitive, investors are willing to do it in the expectation that the asset itself will experience a capital gain that will one day offset the losses incurred. Short-term pain for long-term gain.
If negatively gearing your asset results in a significant tax refund for you, you can seek to reduce your PAYG withheld to free up some cash flow until it’s tax time again. We can certainly help you to do this, however, it requires that some careful calculations are performed to ensure that you don’t wind up with a tax bill, the next time you lodge.
Always Check ABNs
It has been a legislative requirement since the 1st of July 2019 that before making a payment to a contractor for services related to your rental property, you must check the Australian Business Register to confirm that the contractor in question has a valid Australian Business Number (ABN). If the contractor you have engaged does not or cannot provide you with an ABN, or if their ABN is not currently valid, you are required to hold 47% from their fee and pay it directly to the Tax Office. If you do not do this, you are not entitled to claim the associated expense as a tax deduction.
Some exceptions do apply to the above, including private arrangements, services that cost under $75 exclusive of GST, if the supplier is younger than 18 years of age, and so on. You can read more about these exceptions here.
Asked & Answered
“I am currently renting out an investment property and while tenants are still living in the property, I completed some landscaping. I understand that landscaping is an improvement to the property and therefore not deductible under section 8-1. I was wondering if the landscaping would be deductible under Div 43 capital works over 40 years? Or it is merely added to the cost base of the investment property as improvements and no tax deduction allowed?”
Costs involved in landscaping a property are generally seen to be capital in nature. Landscaping would generally amount to an improvement to the property which would have an enduring benefit. These expenses generally need to be added to the cost base of the property for CGT purposes under s110-25 (i.e, can reduce a future capital gain on sale of the property).
You would not generally be able to claim depreciation or capital works deductions in relation to the landscaping work. In order to claim depreciation deductions under Division 40, it is necessary to identify specific items of plant or equipment. Landscaping expenditure would not normally give rise to items of plant or other depreciating assets, although you may have incurred expenditure on items that could be classified as separate depreciating assets (e.g, pumps, etc).
Expenditure on landscaping is specifically excluded from the capital works rules in Division 43. Refer to ATO ID 2006/235 which discusses this issue.
“I have a holiday investment property which is used as an Airbnb business. The property is rented out as a holiday house for the whole year. Could you please advise if the income should be put in the rental schedule or the business schedule in my income tax return?”
If you only have a single residential rental property it is unlikely that this would be a business activity. It is more likely that this would need to be shown in the rental section of your tax return.
Rental income is generally passive in nature and rental activities do not normally amount to a business under general principles, although depending on the scale of the activities it may be possible for some taxpayers to argue that they carry on a business under general principles, rather than merely deriving passive income.
Where the owner of a property is not a company, then the ATO provides some recent guidance on whether rental activities can amount to a business in LCR 2018/7. This LCR is dealing specifically with the travel deduction changes for rental property owners.
TR 97/11 sets out the general indicators of whether an entity is carrying on a business.
IT 2423 also briefly discusses whether rental income constitutes proceeds of a business.
In the case YPFD v Commissioner of Taxation (2014) AATA 9, a taxpayer with nine rental properties was considered to be carrying on a business of property rental largely because the taxpayer actively supervised the real estate agent employed and managed issues associated with the properties (thus having a discernible pattern of trading to their activities), the capital employed was significant and they had conducted property rental activities for a number of years.
The Tribunal adopted the six factors from the Smith case (2010) as to what activities constitute carrying on a business below:
i) Do the activities have a profit-making purpose;
ii) The complexity and magnitude of the undertaking;
iii) An intention to trade regularly, routinely or systematically;
iv) Operating in a business-like manner and the degree of sophistication;
v) Does a profit or loss arise from a discernible pattern of trading?;
vi) The volume of the operations and the capital employed.
None of the factors above are determinative and they should be considered as a whole.
The ATO also discusses this issue and provides some examples in its rental property guide.
“Firstly, I own a 25% share in a property. The property is managed by an agent and the other owners don’t work and are therefore unable to claim the property losses in their tax returns. Is there a way I can claim 100% income and expenses for this property if I pay for all expenses and receive all the income?
Secondly, there is a loan on this property, which is in two of the three owners’ names, one of which is mine. if this loan was changed to be just in my name, can I claim the interest 100%?”
TR 93/32 confirms the ATO’s view that rental income and expenses need to be recognised for tax purposes in accordance with the legal ownership of the property, except in very limited circumstances where it can be shown that the equitable interest in the property is different from the legal title. The ATO will assume that where the taxpayers are related, the equitable right is the same as the legal title (unless there is evidence to suggest otherwise such as a deed of trust or similar).
This means that if you hold a 25% legal interest in the property then you should recognise 25% of the rental income and rental expenses in your tax returns even if you pay most or all of the rental property expenses (the ATO would treat this as a private arrangement between the owners).
The main exception to the general comment above is that if you and your fellow homeowners have separately borrowed money to acquire your respective interests in the property, then you would all claim your own interest deductions. For example, if you (Person 1) and Person 2 buy a property 50/50, and you used borrowed money while Person 2 used their own savings, then you would claim all your interest expenses while Person 2 would have none to claim.
The fact that the loan is in joint or single names is not all that relevant in a case like yours. The ATO would focus on the use of the borrowed funds. Changing the loan so that it is just in your name should not have any impact on the deductibility of the interest or who claims the deductions.