Simply Junior

Domestic rental property investments remain popular and continue to attract the attention of the Australian Taxation Office.

There tends to be some confusion about how rental property ownership can impact on your tax situation. With that in mind, here is a checklist of some common tax issues for you to consider (especially before you commit to buying a rental property).

If I own a rental property, am I in business? The answer to this question usually surprises people. If you simply own or co-own an investment property or even several properties, you are usually regarded by the Tax Office as an investor who is not carrying on a rental property business, either alone or with the other co-owners.

However, even if you are not carrying on a rental property business, this does not mean that you escape the tax net.

How can a rental property affect my tax?

- Acquisition and disposal costs generally are not immediately deductible (e.g., cost of purchasing the property, stamp duty on the transfer, conveyancing costs). Some of these costs may be relevant for capital gains purposes.

- When you rent out a property, the rent you collect and other rent related income (e.g., if you are entitled to retain rental bond money) is assessable for tax purposes. Against this income, you can claim deductions for a range of expenses you incur whilst this property is rented out (or available for rent).

- Where the total rental income exceeds the total allowable deductions, you will have a net assessable amount, which is added to your other taxable income. Where the total allowable deductions exceed the total rental income (this is a negatively geared property), you will generate a loss that may be off-set against your other taxable income.

- When you sell a rental property, you may need to pay capital gains tax on the net sale proceeds. You may also need to pay tax on gains made on the sale of any depreciated items that are sold with the property (e.g., where the property’s fixtures and fittings have been depreciated).

What happens if I own the property with someone else? If you own a property with someone else (co-ownership), your legal interest in the rental property determines your share of rental income and deductions.

The best place to look to work this out is the Title Deed to your property – this will usually identify what sort of legal interest you have:

- if you are a joint tenant, each of you holds an equal interest in the property (e.g., two joint tenants will each hold a 50% interest); or

- if you are a tenant in common, each of you may agree to hold unequal interests in the property (e.g., you may agree for one of you to hold a 70% interest and the other a 30% interest)

How does this type of ownership impact on my tax? If you are co-owners who are not carrying on a rental property business, you must divide the income and expenses for the rental property in line with your legal interests in the property:

- joint tenants always equally share income and expenses – you cannot vary this for tax purposes with some other agreement; or

- tenants in common share in the income and expenses in proportion to the their respective legal interests as set out in the Title Deed.

EXAMPLE John and Mary own a profitable rental property as joint tenants (a 50% interest each) and are not regarded as being in business.

Mary earns no other taxable income, so Mary and John decide it would be a good idea for Mary to receive most of the net income from the rental property and any profit on its eventual sale, so they enter into an agreement to that effect (e.g., Mary 70% and John 30%).

Because John and Mary are joint tenants, this agreement has no effect and Mary and John will still each receive 50% of the net rental income and the net proceeds on any sale of the property.

However, if John and Mary owned the property as tenants in common and the Title Deed indicates that Mary holds a 70% interest and John a 30% interest, then these proportions will usually be applied for tax purposes.

Do I have to pay PAYG on my rental income? Once you earn business or investment income (and this includes rental income), the ATO may notify you that you have to start paying your income tax in instalments (Pay As You Go (PAYG) instalments).

According to the ATO, as a general rule this installment system will apply to individuals who have shown gross business or investment income of $2,000 or more in your latest income tax return and the debt on your income tax assessment is more than $500.

PAYG instalments are usually made at the end of each quarter, but in some cases you may be able to pay an annual PAYG installment if the tax you would have paid on your business and investment income (excluding any capital gain) is less than $8,000, based on your last income tax assessment.

If you had enough money to pay off your mortgage right now, would you?

Many people would. In fact the American Dream is to own a home – and to own it outright, with no mortgage. Imagine owning your home without having to send a cheque to the bank every month, the feeling one will enjoy when – after thirty long years – the moment finally comes to make one last payment so that the house is paid off, at last. Being so fortunate must evoke a sense of security, gratification and well-being that anyone only can dream of.

But if in fact the American Dream is so wonderful, how come thousand of financially successful people – folks who have more than enough money to pay off their mortgages right now – refuse to do so? Why is it that a small group of Americans and Canadians, who are invariably among the wealthiest five percent of the population, insist on carrying on a mortgage even if they can afford to wipe it out entirely today? Because they are aware of the biggest untold secret of homeownership: a mortgage is primarily a loan against the borrower’s income, not primarily against the value of the house. It this was not the case, then naturally anyone with a $30,000 annual income would qualify to purchase a multi-million dollar mansion.

All of which, then, makes the whole difference in the world when it comes to a process known in Economics as the accumulation of wealth. Prosperity in any society and at any given time is the epitome of financial stability, reliability, and security. Specifically in Capitalism, additional capital value (commonly referred to as ‘surplus value’) is what drives the accumulation of wealth. Although capital accumulation does not necessarily require production, ultimately the basis for it is value-adding production which makes net additions to the stock of wealth. Capital can accumulate by shifting the ownership of assets from one place to another, but ultimately the total stock of assets must increase. Other things being equal, if surplus value fails to grow sufficiently, the level of debt will increase, ultimately causing a breakdown of the wealth accumulation process.

This is exactly the reason why saving money has never made anyone rich. For some obscure logic people generally tend to equate the concept of saving money with that of making money, yet the two are not synonymous. As people want to save money in interest payments, they will go the extra length to pay off their mortgages. With that issue out of the way after a considerable number of years, they then start focusing on saving for retirement and do their best to save regularly. As a result, they fail to accumulate wealth and cannot figure out why.

The issue is relatively simple, though not necessarily transparent. By prioritizing mortgage repayments, they fail to consider the role that mortgages play in their wealth building process. The battle to reduce interest expenses is won, but the wealth accumulation war is lost. The reason is that every dollar they have returned to the bank is a dollar they have not invested.

Mortgages today cost anywhere between 5.5 percent to 6 percent annually. Over the next thirty years, on an annual basis, will alternative investments earn at least that much? Of course they will. Even government bonds pay nearly that amount, and stocks have been averaging 10 percent a year since 1926. Thus giving money back to the banks to save 6 percent denies people the opportunity to invest that money where it might earn 10 percent. Which means that, rather than actually saving money, those who opt to pay off mortgages factually lose money. And which, furthermore, goes to explain why bi-weekly mortgage payment plans are not a great idea – because they speed up the process of mortgage repayments.

Specifically as it relates to real estate, furthermore, the irony is that people somehow feel they are making a ‘good investment’ by paying off their home loans. In fact, all they are doing is burying money under a mattress – they are not investing at all. Consumers, and a great deal of them, strive to pay off their mortgages as quickly as possible so they will be able to borrow later on against their equity to pay, among other things, for their kids’ tuition bills. But isn’t that refinancing? Talk about bizarre strategy! Consumers struggle to give banks their money back now, so they can borrow it again in the future. Why don’t they just invest their cash, so that it earns competitive returns and, at the same time, remains available whenever needed?

Their homes will grow in value over the next thirty years whether they have a mortgage or not. When it comes to selling a home, does any Buyer care about what the Seller’s mortgage outstanding balance is? Of course not. And neither does the IRS (Internal Revenue Service) or the CCRA (Canada Customs and Revenue Agency) when it comes to calculating taxable capital gains, losses or recaptures.

The simple truth is that mortgages do not affect home values. But being primarily financial instruments anchored to income, they do affect the wealth maximizing process of investors and market participants by opening up a host of possibilities to invest liquid money derived by consumers’ own income elsewhere, for higher rates of return. Which is what the wealth accumulation process is all about.

There’s two sides to the real estate business. There’s the emotional side where the person is buying [or selling] and then there’s the business side, the non-emotional, logical and rational side. The emotional side is made up of the excitement, frustration, euphoria, fear, etc. that the buyer feels when they’re going through the process of looking at houses, making offers, arranging furniture in their minds as they look at homes, etc.

The business side is the side that most homeowners and prospective homeowners don’t look at. Homeowners and prospective homeowners do not pay attention to this important side.

Therefore, they get involved with real estate agents who are like them. They don’t pay attention to the business aspect of real estate and thus, do not (can not) consult their clients accordingly. These real estate agents know about the market and homes in general. They can tell you alot about a home, type of construction, the heating system, the history of the neighborhood, local home values, etc. But on the business side is the most vital because in the transaction of real estate, is a business transaction. We’re talking about a financial transaction of over $375,000 on the average in the Long Island real estate market.

That is a major business and financial transaction that is cut throat and perfectly rational. It is based on municipal regulations, real estate laws, appraisals, and thorough analysis of the conveyance of title. It requires insurance policies to be executed and title insurance to issued in order to assure clear conveyance of ownership.

The business side of the transaction is where the turkey is talked about. In this market, with changes in the mortgage markets from day to day, if an agent is not thoroughly entrenched in the business side of real estate, they could certainly cost a homeowner and prospective homeowner thousands upon thousands of dollars.

A real estate agent must be empathetic to the emotional needs of his/her clients, while at the same time proficient in representing their business interests which includes helping their bottom line.

I know for me, personally, I pride myself on being “in the know” about mortgage markets, where they’re going and how it will effect both my selling clients as well as my buying clients. For example, higher interest rates will effect my sellers by shrinking the already small buyer pool. Higher interest rates combined with a banking industry that has tightened it’s lending practices so much already, will only make things more challenging for my selling clients because these two important aspects will drive the buyer pool down.

Higher interest rates for my current buying clients/customers means one thing – find a home now, while prices are still down and interest rates are still low because with higher rates comes higher monthly interest payments, which translates to thousands of dollars leaving their income column and going into their expense column. Sure they will get to “write off” the interest at the end of the year, but high cash outlays during the month of say August, totally overshadows the fact that sometime in the future you’ll get a “write off” in taxes.

I consider myself a counselor, consultant, and businessman. While I am human and very much enjoy helping people find a home to buy or help them sell the one they have and buy a new home, I also am a businessman who takes the responsibility of representing my clients business interests very seriously (that’s why my website features such good information and analysis).