There are many reasons why people are attracted to borrow money to invest in bricks and mortar. One of the most common reasons is the ability to offset the cost of owning the property against assessable income – a strategy known as ‘negative gearing’.
Negative gearing occurs when the operating costs of a property is greater than the rental income. In this case, the Australian Taxation Office allows investors to offset the loss against their taxable income.
The resultant tax savings are calculated by multiplying by your property’s operating loss by your marginal tax rate.
Here’s a simple formula to work out tax savings…
A simple formula to calculate the amount of tax you might save by investing in property is as follows:
Gross rental income – (20% of gross rental income to account for expenses) – interest charged in respect to the investment loan used to fund the property = the property’s loss multiplied by your marginal tax rate = tax savings.
Below is a graph illustrating the tax savings obtained for different property values. To calculate the annual tax benefits we assumed a rental yield of 3.5%, lending of the purchase price plus costs at an interest rate of 6%. Operating property costs were assumed to be 25% of rental yield.
As noted from the graph above, the higher your marginal tax rate, the greater the tax savings obtained from your investment. The blue line shows the tax savings obtained if your salary income is within the $87,000 and $180,000 range. While the green line represents the tax savings on salaries above $180,000.
How to maximise your investment property tax deductions
Generally, you can claim a deduction for your expenses associated with the management and maintenance of the property. If you own an investment property there are a wide range of expenses that you can claim as tax deductions. As a general rule, property investors can claim deductions in three main categories:
- Revenue deduction: You can claim deductions such as for the interest on the money you borrow as well as ongoing maintenance and leasing fees;
- Capital items: Large items such as a hot water systems or dishwashers in a rental property are subject to depreciation over time and can be claimed over several years;
- Building allowances: Generally, you can claim for building allowances such as depreciation over time for building works.
There’s a long list of expenses and costs that you may be able to claim as a property tax deduction. An exhaustive selection of these costs are outlined in this checklist (link to checklist).
Also, see this blog which outlines the commonly missed deductions for investment properties.
What are the capital gains tax consequences on sale?
Upon sale of a property, there may be capital gains tax liability. If you hold the property for longer than 12 months, you will obtain a 50% capital gains discount – meaning 50% of the profit is untaxed. The remaining 50% of the profit is taxed at your marginal tax rate.
Perhaps this is best illustrated with an example. Keith purchases an investment property for $500,000 and the total cost of this acquisition is $530,000 including stamp duty. Due to a change in circumstances, Keith sells the property after 15 years of ownership for $1.4 million. The selling costs (agent fees, etc.) amount to $35,000. Therefore, Keith has made a gross capital gain of $835,000 (being $1.4 million – $35,000 – $530,000). Keith is entitled to a 50% discount, so the net gain is reduced to $417,500. This amount is taxed at his marginal rate of say 47%. Therefore, the tax payable is $196,225 (47% of $417,500) – on a gross gain of $835,000 – so effectively 23.5%.
It’s more than just tax savings
Everyone wants to reduce their tax. However, an investment property should be selected as an overall strategy to generate wealth, rather than it being utilised for secondary benefits such as rental yield or negative gearing. A balanced approach is crucial to assessing the viability of an investment property as a wealth creation strategy.
If you have any questions regarding the above or any other tax matter, please contact us.
