Maximising the Tax Benefits of Investment Properties

Maximising the Tax Benefits of Investment Properties Presented by: Anetta Curkowicz Solicitor Thomson Playford Copyright notice © The Taxation Inst...
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Maximising the Tax Benefits of Investment Properties

Presented by:

Anetta Curkowicz Solicitor Thomson Playford

Copyright notice © The Taxation Institute of Australia website and all the content downloaded (except Third Party Products*) from the Taxation Institute of Australia website remains the property of the Taxation Institute of Australia and shall not be reproduced, distributed, displayed or disclosed without the written permission of the Taxation Institute of Australia. *Copyright of the Third Party product applies Disclaimer notice The material published in this paper is published on the basis that the opinions expressed are not to be registered as the official opinions of the Taxation Institute of Australia. The material should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

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Maximising the Tax Benefits of Investment Properties 1.

Potential Audit Targets

2.

Draft Principles Paper

3.

CGT issues

Maximising the Tax Benefits of Investment Properties • As part of 2003/04 Compliance Program:

• 15,000 letters sent out explaining common errors • 5,000 taxpayers to complete rental expenses schedule • Data matching with property sales for CGT compliance • Budget 2004/05: ATO continuing to target investment property and CGT compliance

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Maximising the Tax Benefits of Investment Properties • Common errors ATO is concerned about:

• Co-ownership (splitting of income and expenses) • Interest expenses • Repairs and maintenance deductions • Capital works deductions

Maximising the Tax Benefits of Investment Properties • Co-ownership

• Co-ownership generally constitutes a tax law partnership and not a general law partnership • Income derived and expenses must be brought to account in same proportions as respective interests in property • Partnership agreement has no effect on the sharing of income/ loss from the property (McDonald’s Case)

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Maximising the Tax Benefits of Investment Properties Interest Expenses • Cannot claim interest on loan when property is not rented out or made available for rent • Where rent charged is not at commercial rates, must apportion amount of interest claimed • Where property is used partly for income producing purposes, must apportion amount of interest claimed

Maximising the Tax Benefits of Investment Properties Interest Expenses • Can deduct interest on loan for:

• purchase of depreciating assets • repairs • renovations/extensions

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Maximising the Tax Benefits of Investment Properties Interest Expenses • Mixed purposes loans:

• must have nexus between interest expenditure and purpose for which money borrowed • Part IVA implications • Hart’s case

Maximising the Tax Benefits of Investment Properties Repairs • Ensure initial repairs not claimed as deductible expenses • Ongoing repairs and maintenance are deductible (section 25-10) • Additions, improvements and alterations of a capital nature are not deductible (section 25-10(3))

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Maximising the Tax Benefits of Investment Properties Capital works deductions • What is meant by “capital works”

• buildings or extensions, alterations or improvements to buildings • Applicable deduction rates • What is meant by construction expenditure (section 43-70)

• do not include land value as part of construction expenditure

Maximising the Tax Benefits of Investment Properties Draft principles paper - “Residential Rental Property Assets” • Released 26 March 2004 • Comments are invited • Outlines principles for classifying assets as depreciating assets or capital works • References to old terms - plant, articles and machinery

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Maximising the Tax Benefits of Investment Properties Draft principles paper - “Residential Rental Property Assets” • ATO undertaking review of effective lives based on these principles

• released list of assets and proposed effective lives • examples from list • Draft taxation ruling expected soon

Maximising the Tax Benefits of Investment Properties CGT Issues • Exemptions and concessions available • Clawback of capital works deductions • 3rd and 4th elements of cost base

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Maximising the Tax Benefits of Investment Properties CGT Issues • Main residence to rental property

• utilisation of absence provision in section 118-145 • partial exemption rules in section 118-185

Maximising the Tax Benefits of Investment Properties CGT Issues Example 1 • Bill purchases a main residence in 1992 for $200,000. He is posted to Japan in 1995. He rents the property to Mark. Upon his return in 2001 he continues to rent the property. He sells the property in 2004 for $650,000 and makes a gain of $450,000.

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Maximising the Tax Benefits of Investment Properties Result • Bill can treat the property as his main residence for a maximum period of 6 years, ie. until 2001 • Bill is entitled to a partial CGT exemption under section 118-185

• $450,000 x 1095/4380 days • $112,500 capital gain • 50% discount reduces gain to $56,250

Maximising the Tax Benefits of Investment Properties CGT Issues • Rental property to main residence

• partial exemption rule in section 118-185 is available • section 118-145 absence provision not available

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Maximising the Tax Benefits of Investment Properties CGT Issues • Availability of 50% CGT discount

• for land acquired pre 20/9/85, buildings or structures on land are separate CGT assets from the land (section 108-55) • for land acquired post 20/9/85, any buildings or structures on land are not separate CGT assets from the land

Maximising the Tax Benefits of Investment Properties CGT Issues Example 2 • Katherine has owned an investment property in Norwood since 1971. In January 2003 the home is demolished. Construction for the new home commences in June 2003. Upon completion it is rented but is subsequently sold in April 2004. Katherine makes a $1 million gain.

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Maximising the Tax Benefits of Investment Properties Result • The new home is treated as a separate CGT asset from the land • Gain attributable to the pre-CGT land is ignored • Gain made on the new home is subject to CGT • As the new home is acquired in June 2003 and sold within 12 months, 50% discount is not available

Maximising the Tax Benefits of Investment Properties CGT Issues Example 3 • Lucy purchased some land with an old house on it in August 2003. The house is demolished and a new house is constructed in December 2003. It is rented out and then sold in September 2004.

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Maximising the Tax Benefits of Investment Properties Result • The new home is not treated as a separate CGT asset from the land • Gain made on the new home and land is subject to CGT • As the land was held by Lucy for at least 12 months ie. from August 2003 to September 2004, the 50% discount is available.

Maximising the Tax Benefits of Investment Properties CGT Issues • Small business concessions only available where asset is an active asset as defined by section 152-40 • When an individual is a landlord, their activities unlikely to amount to carrying on business • Even where they are carrying on business, assets used mainly to derive rent are not active assets under subsection 152-40(4)(e)

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Maximising the Tax Benefits of Investment Properties CGT Issues • Clawback of capital works deductions

• where rental property acquired pre 13/5/97 no clawback of capital works deductions from cost base • where rental property acquired post 13/5/97 cost base is reduced by amount of capital works deductions (section 110-45)

Maximising the Tax Benefits of Investment Properties CGT Issues • Query outcome where property acquired pre 13/5/97 and used as main residence and then used as rental property post 13/5/97 • arguable that no clawback due to requirement to “acquire” (as defined in Division 109) post 13/5/97

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Maximising the Tax Benefits of Investment Properties CGT Issues • 3rd and 4th Element of Cost Base

• 3rd element includes all non-capital costs of ownership (section 110-25(4)) • eg. interest on money borrowed to acquire the asset, costs of maintaining and repairing assets and rates

• only applicable to investment properties acquired post 20/8/91

Maximising the Tax Benefits of Investment Properties CGT Issues

• applicable where main residence subsequently used as investment property • non-capital costs incurred while main residence are included in cost base as 3rd element costs • once becomes investment property these costs are generally deductible and not included in cost base

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Maximising the Tax Benefits of Investment Properties CGT Issues Example 4 • David purchased a main residence in 2000 for $350,000. He borrows a substantial amount from the bank. He incurs the following expenses:

• interest expenses of $20,000 p.a. • penalty interest of $4,000 for making early repayments. • $70,000 in general repairs. • $700 in rates per year.

Maximising the Tax Benefits of Investment Properties Result • In 2004 he commences to rent the property • David’s cost base (3rd element) is increased to include:

• interest expenses of $80,000 • repairs of $70,000 • rates of $2,800 • Exclude penalty interest of $4,000 (TR 93/7) • Cost base to date is $502,800

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Maximising the Tax Benefits of Investment Properties CGT Issues

• 4th element includes capital expenditure used to increase value of asset and which is reflected in asset’s nature or state at time of CGT event (section 110-25(5)) • TD 2004/2 • state - ‘condition’ of the thing as with respect to circumstances or attributes • nature - particular combination of qualities, character, kind or sort

Maximising the Tax Benefits of Investment Properties CGT Issues Example 5 • Ben incurs expenditure on improvements to a bathroom for $5,000 (which are not deductible). In 2 years time he renovates the bathroom and removes the improvements. He then sells the property.

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Maximising the Tax Benefits of Investment Properties Result • The $5,000 improvement costs do not form part of the 4th element cost base as they are not reflected in the state or nature of the property when it is sold.

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