Property investors making mistakes, taxman warns

Despite mortgage pressure and economic ructions, property’s rental yields and capital growth have still made it an inviting investment option. But, warns TERRY HAYES of Thomson Legal & Regulatory, tax is often a forgotten obligation.

By Terry Hayes

Despite mortgage pressure and economic ructions, property’s rental yields and capital growth have still made it an inviting investment option. But tax is often a forgotten obligation.

Interest rates may be on the way up, and the property market may be under some pressure, but many people over the last few years have become first-time investors in the property market. The attractions of solid rent returns and capital growth still make these investments inviting.

Rental properties are a perennial problem area for the tax office. In the 2006 tax year, for example, almost 200,000 people claimed rental property deductions for the first time. In total for that year, over 1.4 million people claimed more than $21 billion in rental property tax deductions. It represents a major area of tax office compliance activity.

There are many tax traps with such investments, and investors need to take great care they get their tax position right – and it’s not always easy. The tax office has seen the results of incorrect claims for rental property tax deductions and is concerned that too many errors are being made. And those errors can mean a costly tax penalty.

Common mistakes in claiming rental deductions

There are many, and they include:

• Claiming deductions for rental properties not genuinely available for rent.
• Incorrectly claiming deductions for properties only available for rent part of the year, for example a holiday home.
• Incorrectly claiming the cost of structural improvements as repairs when they are capital works deductions, such as remodeling a bathroom or building a pergola.
• Overstating deduction claims for the interest on loans taken out to purchase, renovate or maintain a rental property. A loan can be taken for both income-producing and private purposes, for example to buy a car or go on an overseas holiday. The interest on the private portion of the loan is not tax deductible, so the whole interest payment has to be apportioned.

The most common rental property expenses that can be claimed as deductions are:

• Expenses for the year they were paid, such as council rates, repairs, insurance and loan interest.
• Expenses that are deductible over a number of years, like borrowing costs, creating structural improvements and costs of depreciating assets.
• Costs associated with acquiring or disposing of a property are not deductible, but they may form part of the cost base of the property for capital gains tax purposes.

Renovation costs and costs to repair damage, defects or deterioration on buying a property are a very common area where mistakes are made. Such expenses cannot be claimed as an immediate deduction.

They are capital expenditure, depending on what is repaired or improved, and must be claimed as either decline in value deductions over the asset’s effective life, or as capital works deductions over 40 years. This can have an effect on cash flow and must be carefully considered. In the rush to get a repair done, the tax implications can easily be overlooked, but it is important to understand the tax consequences first.

The tax office is in the process of examining around 6000 rental income and expense cases (it calls them “at-risk” cases) to look particularly at:

• Incorrect apportionment of interest deductions.
• Claims for capital works that exceed the construction expenditure.
• Initial repair or renovation costs incorrectly claimed.
• Incorrect tax return schedules.

It has so far completed about 3900 reviews which have resulted in almost $35 million in revenue.

Tax law is tricky, so when contemplating making expenditures like those noted above, seek advice before acting and keep good records.

Tax office on the front foot

In an attempt to head off any problems before they occur, the tax office has, over the last two years, been sending letters to people, especially those new to the investment property market who may sell rental properties before they lodge their tax returns, to make sure they are aware of the need to look closely at the tax situation, especially any capital gain made on the sale. This is especially so where a sale of property was used to invest in superannuation during the year.

Don’t forget also that the tax office data-matches property sales with all the states to check that real estate transactions are correctly accounted for in a tax sense. Where there has been a property sale, the tax office first checks to see if a capital gain has been returned. It also checks to see if the property was the person’s principal residence.

Where, from the data-match, a person’s name does not appear on the tax office database, it raises the possibility that the person has not been lodging tax returns. So data-matching can lead to consequences beyond, for example, returning a capital gain.

There is no substitute for taking good professional advice when investing in a property – there are just too many traps for the unwary investor. The tax office also provides its own guidance via a useful publication entitled Rental Properties 2007, which is available on the tax office website.

Terry Hayes is the senior tax writer at Thomson Legal & Regulatory , a leading Australian provider of tax, accounting and legal information solutions.

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