About 1.7 million property owners use negative gearing – where the income generated by rental payments does not cover the interest on the home loan – to claim the losses as a tax offset. This generated a net rental loss of $6.5 billion for the 2010/11 financial year, according to the Tax Office. With figures as significant as these, it may be prudent for taxpayers and their agents to review the tax treatment of certain rental property items. This article focuses on the areas where most of the mistakes were made and provides the ATO’s view on how these items should be treated for tax purposes.
When is interest deductible?
Deductibility is determined by the use of the borrowed money rather than the security provided. Interest on funds borrowed for private purposes is not deductible.
For example, Mike owns his home outright. He decides to buy a new home to live in and rent out his old home. He borrows money to buy the new home using his old home as security. The money borrowed to buy the new home is for private purposes, and therefore the interest on the loan is not deductible. The fact that Mike had a mortgage against his old home, which he now rents, does not alter the fact that the money was borrowed for private purposes. Mike is therefore not entitled to a deduction for the interest.
Linked and split loans
The popular linked and split loan products have also caused some problems. These loans provide finance for both a private home and investment purposes. They are marketed on the basis that people can pay off their home loans faster and get greater tax deductions for interest, by paying off their private loan first and letting the interest accumulate on the investment loan. The ATO does not accept that taxpayers are always entitled to the extra tax deduction on the investment loan.
Tax Rulings TR 98/22 and TR 2000/2 both consider the deductibility of interest incurred in respect of certain linked and split loans. More recently, TD 2011/D8 discussed how Part IVA may apply to similar arrangements which make the payment of interest on the capital sum paid in reduction of the home loan tax deductible.
These rulings should be carefully considered before making a claim for interest on linked and split loans.
Interest apportioned
Interest on a loan used for both investment and private purposes needs to be apportioned. The interest which relates to that part of the loan used for private purposes is non-deductible.
For example interest paid on money initially borrowed to purchase a rental property but used in part to buy a car or pay off a credit card will not be fully deductible. Only the interest relating to the money borrowed for the investment property will be deductible.
Other interest issues
- If a rental property is held in joint names, the interest needs to be split according to the legal ownership of the property and not claimed solely by the income earning partner(s).
- Interest deductions may be limited in domestic arrangements. For example, where a property is rented to a family or friends at less than a commercial rate of rent, the interest may be calculated on a pro rata basis limited to the amount of rent actually received.
- Interest paid in advance may be deductible in the year in which it is paid, provided the interest relates to a period of less than 13 months and the debt is due and payable to the mortgagee. Voluntary advance payments towards the principal of the loan are not deductible.
- Another common error is where the amount of the loan repayments is claimed as an interest deduction. This is not correct. As the repayments generally comprise both interest and principal, the interest component is the only part of the loan repayment that is deductible, unless it is an interest-only loan.
Initial repairs
Expenditure incurred in repairing a newly or recently acquired rental property is capital expenditure and non-deductible. However, the cost of initial repairs may be included in the construction cost of the building and give rise to deductions at 2.5 per cent per annum.
They may also be taken into account when working out any capital gains when the property is sold.
Repairs or improvements?
Expenses incurred in the maintenance and repair of a rental property are generally deductible, to the extent that the repairs involve restoring an item to its original condition.
For example repairs to replace a broken window, maintaining plumbing and repairing electrical appliances are all deductible. However the costs of any alterations, additions or improvements are regarded as capital expenditure and are not deductible.
Depreciation claims
There are two common errors relating to claims for depreciation:
- Valuing items that are acquired with the property where no cost is specified. In arriving at the cost of such items for depreciation, a fair market value needs to be determined taking into account the age and condition of the items. The estimate must not be based on the current replacement price of the item as new. If the property acquired is not used for rental purposes for several years, the starting point for depreciation of items when the property is rented must include the period for which items were owned when they were non-income producing. For example, Mark decides to let his home after living in it for three years. The opening value of the depreciable items should be a reasonable estimate of the cost of the items at the date of purchase, less depreciation for the three years when the property was not income producing.
- Structural items. Depreciation is not allowable for items that form part of the building structure. According to the ATO, there are two ways to distinguish between structural items and items of plant:
- An item is considered to be part of the building structure if it cannot be detached without causing significant damage to the item or to the building. For example, built-in wardrobes, wall installation, plumbing and electrical wiring.
- Some items that may be removed without causing significant damage such as kitchen cupboards, bathroom vanity units, doors and door furniture are also considered to be essential parts of a residential building and therefore are not depreciable. However such items may be deductible under the provisions relating to the extension, alteration or improvements to buildings Division 43 of the 1997 Tax Act.
Building write–off
A depreciation claim for construction costs of building and structural improvements should be based on actual costs incurred. If the actual cost cannot be determined the claim should be based on an estimate provided by a quantity surveyor or an independent qualified person.
What the ATO does not emphasise is that a large proportion of residential property investors fail to claim the building depreciation deductions to which they are entitled.
Disclaimer
The views in this article are those of the authors and do not represent the views of Deloitte Private or Deloitte Touche Tohmatsu or any of its related practice entities. This article is provided as general information only and does not consider anyone’s specific objectives, situation or needs. You should not rely on the information in this document.
