Click here to watch the Video.

Residential property investors take a keen interest in how to treat rental income and expenses for tax purposes, particularly tax deductions for loan interest and repairs.

The Australian Taxation Office (the ATO) publishes the Rental Properties Guide annually. In the 2022 edition, the ATO explains how to treat more than 230 residential rental property items.

This commentary is based on the Guide.

See my introductory video - Tax Deductions for Landlords – for a discussion of some practical aspects.

A brief review of rental income is followed by a detailed analysis of rental expenses claimable as tax deductions.

Rental Income

There are three types of income from rental properties:

  1. Rental income under a standard residential lease or a short-term holiday rental;
  2. Reimbursements by tenants for utilities, water usage and damage caused to the property;
  3. Insurance payouts for loss of rent.

All are taxable as income.

If a property is owned jointly, then the rental income and expenses are divided according to the legal ownership shares of the co-owners. The co-ownership could be direct in personal names, or indirect as shares held in a company or units in a unit trust.

Can co-owners agree to divide the income and expenses in any other way if one pays more of the expenses or wants to receive less income for tax purposes? Unfortunately, that is not possible without transferring ownership and incurring paying stamp duty, legal fees and capital gains tax on the transfer. The one exception is if they own multiple properties and actively manage the properties as a business of letting rental properties.

For this reason, great care needs to be taken to choose the right ownership structure when buying an investment property.

Rental Expenses

Rental expenses are all tax deductions for landlords, but their tax treatment differs depending on which of these five categories they fall under:

  • Property Ownership Expenses
  • Property Management Expenses
  • Loan Expenses and Loan Interest
  • Depreciation (loss of value) deductions
  • Capital Works deductions

 

1. Property Ownership Expenses

Some expenses are part and parcel of property ownership. If the property is a rental property, the expenses are fully tax deductible. They are:

  • Local Government / Council Rates
  • Water and Sewerage Rates, Levies and Charges
  • Insurance (building, contents, public liability, loss of rent and malicious damage)
  • Strata Levies (but not special levies for capital works)
  • Land Tax

 

2. Property Management Expenses

Property management expenses fall under these categories:

  1. Rental: Advertising and letting fees for new rentals, property management fees for rent collection and inspections, lease preparation fees, statement fees, annual fire protection inspections, pest control, evicting tenant, cleaning up the property and disposing of abandoned good.
  2. Repairs and maintenance: If an expense is for repairs and maintenance, it is fully tax deductible in the year of expenditure, if the rules are followed.
  3. Tax affairs: The cost of managing tax affairs, including bank charges, bookkeeping fees, stationary, telephone and postage, and tax-related expenses is deductible.
  4. Seminars: The cost of property investment seminars is deductible if the seminars relate to operating or maximizing the return on currently owned properties. They are not deductible when looking to buy a first property.  

Repairs and maintenance are the most contentious claims because the landlord wants to call everything repairs and maintenance to claim an immediate tax deduction while the ATO wants to call everything replacements or improvements which are deductible over a number of years. These are some rules:

  • What is a repair? Repairs must relate to wear and tear to the property while it is rented. For example, an electrical repair to replace a faulty or broken light switch or light fitting, a plumbing repair to replace a washer in a leaking tap, a roofing repair to replace broken tiles and flashing, a glazing repair to replace broken window glass, a blind or shutter repair to replace cords and slats, and a floor repair to patch or replace broken floor tiles, damaged carpet or hardwood flooring. The expense is fully tax deductible in the year of payment.
  • When is it a repair and when is it a replacement? A new stove element to replace a broken or faulty element is a repair, a new stove is a replacement. The same applies to a dishwasher and air-conditioning unit. The cost of a replacement appliance is tax deductible as depreciation over time.
  • What is an improvement? It is an improvement if a whole structure or unit is replaced. For example, instead of repairing a broken hinge or a damaged panel in a kitchen cupboard or built-in wardrobe, a new kitchen cupboard or built-in wardrobe is installed. It does not matter whether the damage was caused by a tenant or an external cause, such as water damage. The new kitchen cupboard or built-in wardrobe is an improvement and is tax deductible as capital works, not depreciation.
  • What is maintenance? Maintenance is keeping the property in tenantable condition. For example, repainting, trimming trees, lawnmowing, clearing gutters and drains, steam cleaning carpets, servicing the air-conditioning unit.  The expense is fully tax deductible in the year of payment.
  • Initial repairs are not claimable. If a property is purchased and repairs are carried out before it is tenanted for the first time, then the expense is treated as a capital cost and is not deductible. It is capital in nature because the purchase price of the property reflects its condition and state of repair.    

If you own a property, it is a good idea to inspect it regularly. Until 2017, it was possible to claim travel and accommodation expenses for these inspection visits as a tax deduction. But no longer. This tax deduction was abolished because landlords were abusing it to pay for holidays on the coast, such as on the Gold Coast. Note: travel expenses are available if the owner is in the business of letting rental properties.

3. Loan Expenses and Loan Interest

Loan expenses incurred in obtaining a loan are tax deductible over a period of five years, one fifth each year. If the loan is for less than five years, or is paid out in less than five years, then the loan expenses can be deducted over the lesser period.

Annual loan fees, loan payout and mortgage discharge expenses are fully deductible when incurred.

Loan interest. In a standard home loan or investment loan, the loan repayments will consist of principal and interest over 30 years. Only the interest component is tax deductible. The principal goes towards paying down the loan and is not tax deductible because it is capital in nature.

For the interest to be tax deductible, the loan must be for the purpose of acquiring or owning or improving a rental investment property. If a loan is used to finance or reimburse the expenses of a renovation, repair or improvement upon a rental investment property, then the interest is tax deductible.

But if the loan is not used for a rental investment property and is used instead for a private purpose such as to buy a motor vehicle, to purchase or renovate the taxpayer’s residence or to pay for a holiday, or if the property ceases to be a rental property, then no tax deduction is available for the interest or for the loan expenses on that loan.

If a loan is partly used for the rental investment property and partly for private purposes, then the interest is apportioned and the part attributable to the rental investment property is tax deductible.

If the net rental income (that is, gross rent, less rental expenses) is less than the interest payable on the loan for an investment property, then the owner makes a loss on the property. This is called negative gearing. That loss is able to be used as a tax deduction against other income of the property owner, such as salary income.  

4. Depreciation (loss of value) deductions

The Australian Taxation Office (the “ATO”) recognises that appliances, flooring and window coverings have an effective life of between 5 and 20 years.

The ATO allows depreciation, which is an allowance for the loss of value of these items over their effective life. But they must either be mechanical or removable (that is, not permanently fixed to the structure).

To illustrate, let us look at what is depreciable in a kitchen, a bathroom, a bedroom and a living room. The rate for depreciation used is the prime cost method, which is the depreciation method used where the value of the rental property asset decreases uniformly by a fixed percentage of the cost over its effective life.

Kitchen

  • Dishwasher – 8% pa
  • Stove / cook top / oven – 12% pa
  • Range hood – 12% pa
  • Hot Water System – 12% pa
  • Kitchen cupboards, kitchen sink, taps, benchtops, splash back and floor tiles – no depreciation because they are permanently fixed

Bathroom

  • Exhaust Fan – 10% pa
  • Vanity, mirror, toilet, shower fittings, lights, shower screen, floor and wall tiles, plantation shutters – no depreciation because they are permanently fixed

Bedroom

  • Ceiling fans – 5% pa
  • Carpet – 8% pa
  • Built-in wardrobes, window shutters – no depreciation because they are permanently fixed

Living room

  • Ceiling fan – 5% pa
  • Flooring: vinyl – timber hybrid flooring – 10% pa, hardwood flooring – 15% pa
  • Airconditioning unit – split system / reverse cycle – 10% pa
  • Window blinds – 10% pa
  • Window curtains – 6% pa
  • Light fittings (without a fan), plantation shutters – no depreciation because they are permanently fixed

The percentage is tax deductible every year.

These are some rules:

  • Depreciation is limited to new items the landlord installs. A new owner cannot continue the depreciation for items installed by a previous owner, when purchasing a property.
  • The exception to this rule is the purchase of a new residential property. Depreciation is available if no one was previously entitled to a deduction for the asset, and either no one resided in the property until it was acquired or the property was acquired within six months of it being built (even if it was tenanted during that period).
  • No claim is available for depreciable items acquired second-hand.
  • If an item is destroyed while it is still being depreciated, then the unclaimed depreciation cannot be claimed as a tax deduction. 
  • For items which cost up to $300 and are depreciable, such as a new exhaust fan, the expense is fully tax deductible.  

5. Capital Works deductions

The construction or renovation of a building is capital works.

For example, if you build a house or add an extension to a house, such as a room, garage, patio or pergola, or structurally alter property by removing an internal wall. This extends to improvements assets which are permanently fixed.

Almost the whole fit-out of a bathroom, the floor and wall tiling, the vanity, the toilet, the shower fittings and screen, and the lights are capital works. In a kitchen, the kitchen cupboards, the benchtops, the kitchen sink, the tap fittings and the splash back are capital works. In a bedroom, the built-in wardrobes and the shutters on the windows are capital works.

The ATO allows a tax deduction for capital works of 2.5% pa of the cost over a period of 40 years after the capital works were completed, for investment properties.  If the tax deduction is not claimed when available, the tax deduction is lost.

A Quantity Surveyor can prepare a Tax Depreciation Schedule which estimates the construction expenditure if the exact figures are not available. The cost of the Schedule is fully tax deductible in the year of expenditure, as a cost of managing your tax affairs.

If the building is damaged or destroyed, the amount that remains to be deducted for capital works is tax deductible, after the insurance proceeds are credited.

Unlike depreciation deductions, capital works deductions will reduce the cost base when calculating Capital Gains Tax on sale of the investment property.

Expenses not deductible

There are many expenses for an investment property that are not tax deductible. Some are:

  1. Acquisition costs (including legal costs, stamp duty, buyer’s agent’s commission, inspections) and sale costs (selling agents commission, marketing costs and legal costs) are capital costs. These are added to the cost base when calculating Capital Gains Tax.
  2. Private use. If the rental property is a holiday home which is used for private purposes for part of a year then expenses are apportioned to be not deductible for that part of the year and be deductible only for the part of the year it is rented or is genuinely available for rent. The same applies if only part of the property is used to earn rent, such as a self-contained flat. And the rent must be market rent.
  3. Vacant land. If the land either does not contain a substantial and permanent structure or does contain a structure which is habitable but not yet rented or available for rent, then it is treated as vacant land and no tax deductions are available for expenses. A caravan is generally not considered to be residential rental property.
  4. Outside of Australia. If the property is located outside Australia, special rules apply.

Disclaimer

Tax is a complex topic. This article provides general, simplified advice. The advice in this article cannot be relied upon in specific situations, even if it sounds very similar to a specific situation. Expert tax advice is needed, having regard to objectives, financial situation and needs.