Another financial year has concluded and it’s tax time once again. For most property investors, commercial or residential properties alike, the thought of having to complete a tax return is onerous but necessary.
To make things worse, the tax return has evolved in complexity to such an extent that the correct preparation of the entire return without enlisting the assistance of a tax professional is virtually impossible if your financial affairs involve more than just the run of the mill salary and wages.
On top of all that is the unthinkable ramifications of getting the tax return wrong, which has the potential of attracting the unwelcomed attention of the dreaded tax office.
To help you and your tax advisor avoid some of the pitfalls in preparing tax returns for rental properties, here is a list of the 10 most commonly made mistakes people make on their tax returns in respect of their properties. These will hopefully help you avoid some of the pitfalls in the course of preparing this year’s tax return:
Common Mistake #1: Repair or improvement?
There is a fundamental difference between a repair and an improvement – the former is tax-deductible, but the latter is considered capital and therefore not tax-deductible.
An easy way to determine if something is a repair or an improvement is to ask the question – did the work done restore something back to its original condition or did it improve it to a condition that is beyond its original state? If the answer is the former, the cost will be tax-deductible, provided that the work does not constitute initial repairs.
Generally, an initial repair is repair work done before the property becomes available for rent. The cost of an initial repair is deemed to have been incurred before the income producing purpose of the property arises, which means the cost is considered capital in nature and is therefore not tax-deductible.
On the other hand, improving something to a state that is beyond its original condition is also capital in nature, which is not tax-deductible. In many instances, it is not always possible to restore something back to its original condition simply because the components or parts required to repair that thing have become obsolete and are no longer available. In which case, the tax office will still accept the work done as a repair provided that the components or parts that have been used to do the repair work are modern equivalents of the original materials.
Also, the tax office routinely reviews repair claims and demands justification to defend the claims from time to time. Therefore, it is very important that the repair expenses you are claiming in your tax return are defensible.
Common Mistake #2: Non-deductible costs
Just because something is not tax-deductible does not mean it simply fades into the tax black hole and is therefore “dead money”. You need to bear in mind that any work done on a property that is capital in nature may still attract some tax perks.
If the thing acquired is a free-standing functional unit, it may be classified as a depreciating asset on which you may claim a depreciation deduction. If the thing acquired is affixed to the building, it may constitute “construction expenditure” on which you may claim a building allowance deduction. If worst comes to worst and the expenditure does not fall under either of these categories, it may still be included in the cost base of the property, which may reduce the future capital gains tax payable if the property is sold.
In sum, the moral behind the story is – be pedantic with any cost you incurred on the property. Save every bit of paperwork (eg, receipts, invoices) because chances are it may reduce your tax in one way or another.
Common Mistake #3: Building allowance
As alluded to above, you are generally allowed to claim an annual building allowance of 2.5% or 4% on the construction expenditure incurred on structural improvements that is attached to land.
However, construction expenditure is not synonymous with the amount one pays to acquire the property. It is the capital expenditure originally expended to construct the building or improvement.
In other words, you cannot claim the building allowance on the contract price, for instance. Rather, you need to ask the vendor to provide you with the remaining balance of construction expenditure that may be claimed (the vendor may already have claimed some building allowance in respect of the construction expenditure). Alternatively, a lot of people are not aware that they can buy a depreciation report from a qualified quantity surveyor to substantiate their claim, which is generally accepted by the tax office. Such a report generally costs about $500, which will pay for itself.
The most common mistake people make in relation to the building allowance claim is that they often omit the claim or they calculate the claim based on the contract price of the property. Also, depending on when the property was originally acquired, the cost base of the property will need to be reduced by the cumulative amount of building allowance claimed during the ownership period of the property, which has the effect of increasing the capital gain or reducing the capital loss upon the sale of the property.
Common mistake #4: Interest is interest is interest
Most people assume that any loan drawn down that is related to their rental property is immediately tax-deductible. While this is generally true, the deductibility of interest is contingent on a strict tracing of loan funds to determine if they have been used for an income producing purpose.
For instance, if someone withdraws funds from a redraw account and uses the funds to buy a home, the interest on the funds will not be tax-deductible, even if the redraw account was originally established to buy a rental property. The purpose of the redrawn funds, in this instance, is treated as relating to the acquisition of the private residence, which will render the interest incurred on the borrowed funds non-deductible.
Another common situation is when borrowed funds are used for mixed purposes. Obviously, the interest incurred on such a loan account will not be wholly tax-deductible and an apportionment of the deductible portion of the interest is required. However, it should be noted that if any repayment is made on the loan, the repayment will also need to be apportioned between the private and income producing purposes on a reasonable basis, which may be a point of challenge by the tax office. That is why the best thing to do is always to have separate accounts for private and income producing funds.
As interest is usually the largest claim for a rental property in the tax return, any knock back from the tax office may affect the tax position of the investor drastically. That is why the original financing of the property purchase is of utmost importance as the manner in which property was financed has a direct bearing on the future deductibility of the interest expense incurred on the loan funds.
Given that the amount claimed for interest is usually the focal point of the tax office due to the quantum of the deduction claim in the tax return, you need to be confident that the interest is clearly traceable to an income producing purpose.
Common Mistake #5: Borrowing costs
Another mistake people often make is that they either include the borrowing costs associated with the acquisition of the property in its cost base or they claim the total borrowing costs outright as a tax deduction. Neither of these is the correct treatment of borrowing costs.
By way of context, borrowing costs are costs associated with the access of loan funds that are used to purchase a property. Common borrowing costs include bank fees, valuation expenses associated with the borrowing, mortgage insurance, etc.
The correct treatment of borrowing costs is – if the amount incurred is less than $1,000, it may be claimed as an immediate tax deduction. If the amount exceeds $1,000, the amount will need to be claimed progressively over the life of the loan or 5 years, whichever is shorter.
Common Mistake #6: Legal fees
Along the same vein, legal fees related to the purchase or sale of a property are included in its cost base and are not tax-deductible. However, legal costs incurred to deal with the day to day operation of the property, eg, drawing up a lease, disputing with tenants, etc, are tax-deductible. Fortunately, costs for qualified professional advice and assistance that are attributable to managing your taxation affairs are generally tax-deductible upfront.
Common Mistake #7 Body corporate fees
Most property investors seem to think that body corporate fees are categorically tax-deductible.
While this is generally true for regular body corporate fees, that are essentially funds used by the body corporate manager to manage the day to day operation of the property, special levies and sinking funds that are used to fund capital improvements on the property are not tax-deductible even though they are usually included in the normal quarterly body corporate fee invoices.
For example, in addition to the regular body corporate fees on an invoice, the body corporate may charge a special levy to upgrade the front entrance of the property. That special levy included in that invoice will not be tax-deductible, which is often mistakenly claimed in a tax return.
Common Mistake #8: Travelling expenses to inspect property
I cannot recall the number of times when I overheard people boasting about the tax-deductible holiday they just had as they were claiming the travelling expenses as a tax deduction on the basis that they were costs incurred to inspect their income producing property.
It is without a doubt that bona fide travelling expenses incurred by say a landlord to inspect their rental property is tax-deductible. However, the availability of the deduction is contingent on the extent of the income producing purpose behind the trip.
For instance, if your primary intention to travel to a particular location is to inspect your property but you also intend to use the opportunity to go on a holiday, there will be multiple purposes behind the trip, which means that the associated travelling expenses will need to be reasonably apportioned and only the income producing portion of the expenses should have been claimed in the tax return.
Common Mistake #9: Available for Rent?
As discussed in the last point, an expense is only tax-deductible to the extent that the property is used for an income producing purpose. Therefore, if a property is not available for rent for a part of the year, the expenses incurred on the property for that year will need to be apportioned. This apportionment is often not taken into account in the tax return, which will pose audit risks if the tax office decides to review the claims.
You need to distinguish between a property being not available for rent and a property being left vacant but is available for to rent. The latter generally does not give rise to a need to apportion the expenses because so long as the property is available for rent, its purpose remains income producing, even though it is temporarily not tenanted.
To determine if an untenanted property was available for rent, the tax office generally looks for evidence to see if the property was being actively marketed to procure tenants. Therefore, evidence such as advertising agreements with real estate agents in respect of the untenanted period will become very useful.
Common Mistake #10: GST
Residential property leasing does not attract GST, but the leasing of commercial properties does so if the landlord is registered for GST or is required to be registered for GST. That is why investors who move from investing in residential properties to commercial properties are often not aware of the GST implications of their newly acquired commercial properties.
Generally, if you own commercial properties and the combined projected annual rent of these properties will exceed $50,000, you are required to be registered for GST. This will also mean that you are automatically liable to GST on 1/11th of the gross rent, which must be paid to the tax office.
On the other side of the coin, you may claim back the GST included in the expenses you incurred on your commercial properties.
In addition, there may also be GST implications associated with the purchase and sale of commercial properties. Professional advice is highly recommended as the relevant law is relatively complex.
If you own commercial properties and are required to be registered for GST, you will need to ensure that the amounts you report in your tax return in respect of the properties are GST-exclusive.
Need further help?
If you suffer from insomnia or would like to read up on all the tax intricacies regarding your rental property, the tax office publishes an annual Rental Properties Guide, which sets out the Commissioner of Taxation’s interpretation of how the law applies to rental properties.
Be mindful though that the contents of the guide depict the Commissioner’s view of the world, which may or may not represent the correct interpretation of the law. Therefore, your tax advisor will be an invaluable resource to guide you through the trauma of lodging your annual tax return.
Eddie Chung from BDO Kendalls’ Private & Entrepreneurial Client Services can be contacted on
(07) 3237 5999 or via email at eddie.chung@bdo.com.au.
For further information please contact:
Helen Pham of BDO Kendalls on (07) 3237 5713 or helen.pham@bdo.com.au
or Sue Monk of Bayly Willey Holt on (07) 3368 2355 or sue@bwh.com.au.