Four Important Investment Property Tax Reduction Tips
Every person’s needs can vary greatly regarding investment property tax strategies. Before making any decisions, you should always talk to an accountant who is intimately familiar with your personal circumstances. Strategies that look good on paper may hurt you in unexpected ways. Moreover, tax laws tend to vary by state. And lastly, you should also talk to a reliable mortgage broker to see how your tax strategy will affect different loan structures.
All that aside, it is always helpful to gain an understanding of the consequences of certain tax strategies.
Towards that end, Mortgage Corp worked with Craig Ball, the property investment accountant from Precision Business Advisory to put together these tips on investment property tax. In this article, we’ll drill down into the details of several tax topics relevant to property investors, including:
- The pros and cons of using a trust to buy an investment property
- How to structure property ownership to minimise tax payments
- The good and the bad of capital gains implications
- How using property depreciation can help you reduce your tax bill
Buying an Investment Property Under a Trust: Pros and Cons
Purchasing an investment property using a trust is a common practice for property investors throughout Australia. But that doesn’t mean it’s the right move for everyone. The following pros and cons will give you an idea of the tax implications of buying an investment property under a trust, but (as you’ll see) it ultimately depends on individual circumstances.
Pros of Property Investing Under a Trust
Buying an investment property in a trust is ideal for asset protection, long-term wealth generation, succession planning, and tax minimisation (in most cases).
Asset Protection
Because a trust is treated as a separate legal entity, if the property trust is sued for a property-related issue, the owners of the trust will not be party to any litigation. This is significant because it protects property investors who own assets in a trust from personal liability.
By purchasing property in a trust, property investors also protect the assets they put into the trust from litigation. For example, if a creditor was to lay claim against a family member who owns property in a trust, the assets in the trust would be protected from the creditor.
For families and some business partners, this is extremely important. Without the asset protection of a trust, a lawsuit brought against a single person with assets in the trust would put the entire trust in danger.
The asset protection provided by trusts is made possible by the fact that the owners of a trust don’t have any ownership rights to the trust assets.
Succession Planning
Gaining wealth is one thing. Preserving that wealth is an entirely different, and challenging task. Property trusts help facilitate wealth preservation by serving as an effective way to pass assets from one generation to the next. Detailed instructions for how assets are to be divided up and controlled are provided in the terms of the trust deed.
The fact that a trust gives property investors the opportunity to spell out instructions for how they’d like their estate to be handled is hugely significant. It helps prevent the need to go to probate which takes time and money, plus it reduces the likelihood of a tax event.
In a family trust, the control of assets passes to the next appointor (the person who controls the assets) on the death of the current appointor of the trust. Another benefit to succession planning that trusts provide is that assets do not need to be sold or transferred on death.
Income Splitting
The terms of the trust deed may spell out how much of the trust’s income that each beneficiary of the trust is entitled to. This provides flexibility for tax purposes because the trustee has the power to determine who receives what portion of the net income from the trust.
Because beneficiaries are only required to pay the tax on their portion of trust income, a properly structured trust is an investment property tax tip that benefits property investors quite a bit.
Capital Gains Benefits
The assets in a trust are eligible for the same 50% reduction in capital gains as other assets, provided the assets are held for at least one year. Compared to holding assets in a company, a trust has a significant advantage because companies are not eligible for the 50% capital gain reduction.
Property investors are further benefitted by the ability to carry forward losses in a trust. This means that if you bought an investment property under a trust, any losses from that property can be applied against the trust’s net income in later years as a deduction.
This is great for property investors because they can limit losses and increase gains by saving on their tax bill.
Cons of Property Investing Under a Trust
No Negative Gearing
Property investors with assets purchased under a trust do not benefit from negative gearing the way property investors who buy property without a trust do. That’s because losses made by a trust are not allowed to be divided up between beneficiaries.
If the net income of your trust is negative, you’ll have to make up the difference with your own contributions. Even worse, the contributions you make cannot be deducted from your regular income at tax time.
Possible Reduction in Borrowing Capacity
Using a reliable mortgage broker becomes even more important than it already is when you own or purchase property under a trust. That’s because making a home loan to a property investor buying in a trust is complex, and many lenders do not have a good understanding of family trusts.
So, if you own property in a trust, you’ll want to get a loan from a lender that has managed these types of loans. You’ll also want a reliable mortgage broker that has a solid understanding of your finances and the finances of everyone else in the trust.
Land Tax Implications are Higher
Purchasing land is further complicated when the purchase is completed through a trust. That’s because property held by a trust is taxed at the surcharge rate. Individual property investors are taxed at the general rate when they buy and hold land. The general tax rate is significantly lower than the surcharge rate.
However, there is an exception. If the land owned by a trust is the property investor’s principal place of residence, he or she will pay the general tax.
How to Structure Property Ownership
There are two main ways to structure a property purchased by two or more individuals. The property is purchased either as joint tenants, or tenants in common.
Joint Tenants
Joint tenants must obtain equal shares of the property with the same deed at the same time. Put another way, owners who purchase property as joint tenants will all own an equal share of the property. So, if there are two joint tenants, each owner has a one-half interest. If there are three joint tenants, each owner has a one-third interest, and so on.
Tenants in Common
No owner may claim a specific area of the property, but unlike joint tenants, purchasing as tenants in common allows owners to have different proportions of ownership interests. For example, if three people buy a property together as tenants in common, one tenant could own half of the property, while the other two owners each own only one-quarter of the property.
Benefits and Downsides of Tenants in Common
Who should go on title and at what percentage depends on whether the property is negatively or positively geared. As you may have guessed, tenants in common ownership structures give property investors greater flexibility in terms of reducing tax penalties, but there are also downsides. We’ll start with the good news.
Upside: Potential Benefits from Negative Gearing
If two parties purchase a negatively geared property, they will receive a larger negative gearing benefit if the higher income earner of the two parties is the majority owner of the property.
This gives property investors a significant opportunity to reduce their tax bill.
Downside: Loss of Income from Negative Gearing
Because a negatively geared property investment reduces your income, the chance of property appreciation and tax savings must be enough to make up for your loss of regular income.
Accepting some loss of regular income with the chance for appreciation is a very delicate balancing act. You should always talk to an accountant and a reliable mortgage broker before you try it.
Upside: Reduced Tax Impact from Positive Gearing
Two parties who own a positively geared property investment generally want to structure ownership so the lower income earner is the majority owner.
This allows the two parties to reduce the overall tax impact of their property investment.
Downside: Increased Tax Impact on Sale of Positively Geared Property
The downside to the tenants in common structure is that the majority owner will have to bear a larger portion of the capital gains tax if the property is sold at a profit.
As you can see, there are a number of considerations regarding who should be on title and what percentage is owned by who. That’s why it’s so important to talk to a tax professional before you make ownership structuring decisions.
Keep in Mind: Laws Vary for Ownership Structure Issues
In the deed, title or other legally binding document, the terms of joint tenancy or tenancy in common will be spelled out in writing. That said, the laws governing ownership structures differ, particularly when it comes to how property ownership is structured between married couples. In some states, the default ownership for married couples is joint tenancy while in others it is tenancy in common.
If you’re married, you’ll want to speak with your solicitor or conveyancer so you know which ownership structure applies to you. Assuming you’re partnering with a spouse, friend or business partner on a property investment, how you structure ownership has significant short and long-term tax implications
Last Word on Joint Tenants
Buying an investment property as joint tenants is not necessarily a bad thing, even though you don’t have control over ownership shares. If you and your business partner or spouse have similar financial circumstances, it may make more sense to go in as joint tenants.
Capital Gain Tax Implications: the good and the bad
Capital gains considerations are among the most commonly discussed tax topics for property investors, and for good reason. While capital gains issues depend on many factors, taking advantage of the potential tax benefits of capital gains can make or break your investment portfolio.
The Good (but also Bad): No Set Capital Gains Rate
This could be good or bad depending on your situation, but we’ll start with the positive side of it.
Capital gains are calculated in addition to your regular income so there is no set rate of tax for capital gains.
In other words, whatever your marginal tax rate is will be the rate at which your capital gain is taxed. This is significant because you’ll want to time the sale of your properties (if possible) so that the property is sold when you have low assessable income.
For example, most income earners enter their peak earning years during middle age. Generally, once you retire, your assessable income will decrease and so will your marginal tax rate, making retirement a great time to sell property (theoretically).
Consider that you’re 55 years old, own a house in Melbourne, and make $150,000 per year. Your tax rate is based on that yearly salary. For simplicity sake, let’s say you retire 5 years later and your income goes to zero. Now, if you sell your property at a profit of $100,000, the only taxable income you have for that year is your investment profit: $100,000.
If you had sold the property when you were 55 years old, your taxable income would be $250,000. And that would mean paying a significantly higher amount of tax.
This is an oversimplification because other factors may exist, but it’s definitely something to consider.
The downside to there being no capital gains rate is that if you want to (or are forced to) sell your investment during a high-income year, you may face a significant tax penalty.
The Good: Capital Gains Tax Discount
If possible, it’s usually best to hold a property for at least one year. Holding a property investment for a year makes you eligible for the capital gains tax discount. And this discount allows you to reduce your capital gain by 50%. This capital gains tax discount doesn’t apply to assets owned by a company.
The Good: Tax Exemption for Homeowners (Usually)
Unless you rent out a room, your home is exempt from capital gains tax. Any use of your home that is for business purposes, however, will void the capital gains exemption. If you do end up wanting to rent out part or all of your home, you should keep all records so you don’t end up paying more tax than necessary.
While most people focus on rent, any type of business use of your home for profit may cause you to be excluded from the tax exemption, so it’s worth checking with your accountant.
The Bad: Capital Gains are Added to Assessable Income
Capital gains and losses only apply to your regular income. This means that if you make a large capital gain during the year, you’ll end up with a higher tax bill than you’re used to. Moreover, you’re not allowed to apply capital losses against any other income other than capital gains.
Other Capital Gains Considerations
Capital gains issues go hand in hand with ownership structure considerations because capital gains splits are based on the percentage of ownership. Also, buying property under a trust can have implications on capital gains and losses.
Generally speaking, capital gains tax laws favor long-term investors and homeowners over property investors aiming for short-term gains.
Property Depreciation Reduction
Property investors may use property depreciation on investment properties to reduce the amount of tax they pay. Capital works deductions can also be claimed for the same purpose.
Together, depreciation and capital works deductions are the most cost-effective way to write down the value of a property. Perhaps the biggest advantage is that these deductions require no cash payments.
So you, as the property investor, get to reduce your tax bill without paying anything.
How is Depreciation Calculated?
Depreciation is calculated based on an assessment of an asset’s value. This includes depreciation based on plant and equipment and depreciation based on building allowance.
Plant and equipment refers to items within a building: carpets, blinds, ovens, dishwashers, etc.
Building allowance is related to the costs of constructing the building.
While the 2017 Budget has introduced some changes that relate to the depreciation of plant and equipment, using depreciation on building allowance remains a very effective way to reduce your tax bill.
Keep in mind that depreciation is based on asset value, so if you don’t have proof of how much something cost to build, you’ll need to get your property valued. It’s important that you follow the procedures for getting a proper assessment for tax purposes.
Even if you own an old home and have no evidence of how much it cost to build, you’ll be able to take advantage of depreciation.
Capital Works Deductions
Building allowance depreciation and capital works deductions are quite similar. The difference is that capital works deductions are applied to rental properties. Like building allowance, capital works deductions are based on the cost of construction, which includes renovation expenses.
There are some specific restrictions on taking depreciation on your tax return, and eligibility for various property investors may differ. Talk to your accountant for more information about your eligibility to claim depreciation.
Investment Property Tax—Key Takeaway
If there’s one thing you should take away from this post, it’s that finding a team of well-rounded financial professionals is key to your long-term investment success. I touched on several important issues in this post but there are even more complicated tax issues that you could only discuss with your accountant, get investment property tax tips from the experts.
Many property investors fail to take advantage—or simply don’t pay attention to—the Australian tax system. In doing so, property investors are paying tens of thousands in tax (and sometimes more) than they don’t need to.
Browse through our Investment and Home Loan Success Stories to see how Mortgage Corp works within a team-based model to ensure each and every client has a customised solution.
At our Free Loan Strategy Session, we work with a team of experts including solicitors, financial planners and accountants like Craig Ball to make sure your loan is structured to save interest, fees and tax and maximise further property investment opportunities.
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