Tax Compliance – Rental Property Income and Capital Gains
A key issue for investors and multiple homeowners is tax compliance on rental property income and capital gains.
With the Melbourne property market charging towards unprecedented levels of growth and value, largely driven by investors who often do not occupy the property they buy, the fruits of selling your property could be greater at the moment than ever before. Different tax rules apply to different types of residential property, for example, property which is occupied by the owner or property which is rented out to tenants with the owner living at a separate address.
Capital Gains Tax in-particular is important for those selling a rental property, current regulations require those who sell a rental property to calculate any capital gain made on the sale and include it in their tax return. A tax concession is currently available for gains made on the sale of a property which qualifies as the owner’s main residence. For rental properties, this does not apply, and regulations state that the sale of property purchased with the intention of generating rental income constitutes a Capital Gains Tax event.
Property purchased with the intention of selling it to make a profit, or to develop or subdivide the property as part of a commercial venture, results in proceeds from such a sale being assessed as normal income acquired through a standalone profit-making venture.
On this page we will explore the requirements for recording and reporting your income and expenses derived from a rental property.
Record Keeping and Joint Ownership of Property
In the event that a rental property is purchased jointly by more than one party, it is very important that each party’s individual interest in the property is recorded for tax purposes as well as for distributing proceeds from rental income.
For individuals who own or co-own a property used to generate rental income, this income is usually assessed as investment income. This is the case for anyone drawing income from a rental property who is not generating the income as part of a registered rental property business, and according to ATO data, less than one in one hundred rental property owners are involved in a rental property business.
A rental property business is classified according to the following criteria:
• The number of hours devoted to management of the rental property/s, or related activities
• The scale and size of activities related to the properties used to generate income from rent
• The level of organization, planning, and operations involved in managing the rental property/s.
• The degree of personal involvement in the management of the rental property/s.
If the property has been negatively geared, it is very unlikely that it constitutes part of a rental property business, and so any income received from rent is likely to be assessed as investment income.
Records should be kept of all payments or transactions that relate to your capacity to derive rental income from the rental property. These records must be recorded in either plain English, or if in another language, be able to translate directly to plain English.
Any records or documentation used in the presentation of your income tax return must be kept for a period of five years from the date of lodging the tax return. These records may be stored by an appointed party such as your solicitor or accountant, though you should always keep copies for yourself and ensure backups are available.
These records will likely form the basis for the calculation of deductions for expenses, and/or to be used in the event of a dispute with the Australian Tax Office or other body. If you become involved in such a dispute, or if specific records are sought from you by the ATO, you are required to keep copies of the relevant records until the dispute or request for additional information has been resolved.
The following are examples of rental expenses for which records must be kept:
• Name and details of the supplier
• Amount, dollar value of the expense
• Description of the products, goods, or services for which the expense was paid
• Dates that the expense was incurred and when it was paid
• Record the date each time you make a record or modify your expenses records.
If you do not record the dates on which expenses were incurred and paid, you are able to use certain items of independent evidence, such as bank statements, to specify when an expense was paid for. Receipts or invoices can be used to specify when an expense was incurred.
Division of Income and Expenses
If a property used to generate income from rent, the income and any related expenses must be divided between owners based on their share of legal interest in the property. As an example, a couple who jointly owns an investment property used to generate income from rent would each list 50% of relevant income and deductions on their personal tax return.
Where the property is drawing rental income as part of a rental property business, income and deductions are split between the business owners based on the partnership agreement binding them in their business relationship.
Small businesses, including rental property businesses, are entitled to taxation concessions such as special depreciation rules. Investment properties are not entitled to these concessions, and investors are required to report the income as investment income rather than business income.
Note that you are not required to attach copies of these records to your personal tax return, or send these records in to the ATO. The reason that requirements for record keeping exist is so that they can be referred to or relied upon in the event of a dispute, or if clarification of certain matters is sought by the ATO.
In addition to the more detailed records described above, it is recommended that rental property owners maintain a succinct summary of their expenses. This can be done in the form of a list or document which does not contain all the details, but contains enough information to enable you to find the details if you need to at short notice. The information listed in your summary may also be sufficient for filling out the rental property schedule as found on the income tax return lodged each year by individual taxpayers.
Reporting Income Generated Through a Rental Property
When you generate income from a property you own that is being rented out, that income is reported as either rental income or other/rental related income. The income tax return document used to report personal income contains a schedule referred to as the rental property schedule. This is where any income from a rental property, or income related to a rental property, is to be reported.
Rental income – This type of income, for tax purposes, refers to money received as rent payments, or any barter, goods or services received in lieu of rent payments. If you receive a service or product other than money from a tenant in the rental property you own, the monetary value of this service or product must be reported as part of your rental income. As with income earned through work, you report the amount of rental income received during the current reporting period.
Other/rental related income – If you have received any form of booking or letting fee, such as through offering your rental property for short-term accommodation and taking a non-refundable fee during the booking process, this counts as rental related income. Also included in this income type are reimbursements, such as the retention of a rental bond due to damage or rent default, or when tenants pay for services or amenities which you then claim a deduction for. Insurance payouts for rent default may be reported as other rental income, but other forms of insurance payout are assessed as capital and need to be reported as such. Speak to your accountant if you are unsure about which income type is which and how they relate to your circumstances.
It is also important to note that investment or rental income must be reported when it is received, even if it is received by someone else on your behalf and you are not actually in possession of it during the reporting period. An example of such a situation may be that rent payments are collected by an agent on your behalf, you would be required to report those payments as rental income even if the money is still in the agent’s possession.
Additionally, income is derived where it is directed by you or on your behalf, even if you do not receive the money. For example, if you direct the tenant in a rental property you own to make rental payments into the account of a third person and not yourself, the money paid by that tenant to the third party forms part of your assessable income.
Expenses and Deductions
Many expenses incurred through the operation of a rental property are deductible, so long as they are connected to the earning of income through rent. Deductions may be claimed for certain expenses incurred during the period in which the rental property was available to rent or was occupied by a tenant.
If you purchase land upon which you intend to construct a rental property, than many of the applicable rates such as water, sewage, council, and emergency services rates are deductible. If at any time your intentions change and you decide to use the land for private purposes, other than for the production of rental or business income, then these deductions no longer apply.
Any private expenses are not deductible, expenses need to be connected to the production of income in order to be deductible.
Capital expenses are also non-deductible, so you cannot claim a deduction on the expenses incurred during the acquisition or disposal of your rental property. Borrowing costs, on the other hand, may be deductible, as are depreciations in value or certain capital works.
Apportionment of Expenses
In some cases, you may not be able to claim a deduction on the complete value of certain expenses. In these cases, the expenses need to be apportioned, that is, divided into deductible and non-deductible portions. The following are examples of situations in which expenses would need to be apportioned in order claim a deduction:
• If you rent a property out at rates considered to be significantly below market value, for example, if you allow friends or relatives to rent accommodation from you at a low cost. In these circumstances, deductions may be limited to the value of rent actually paid.
• If you are a part owner of a rental property, expenses and income must be apportioned to reflect your ownership stake or percentage.
• Where only part of a property is used to derive income from rent, only expenses directly related to the generation of rental income may be claimed. In such cases, apportionment of expenses is conducted on the basis of floor-area; by calculating the floor-area used to generate rental income you can apportion the deductible expenses as a ratio of rental floor-area to total floor-area.
• If more than one rental property is owned, some expenses need to be apportioned appropriately. If you wish to claim travel expenses, but you inspect two properties in a single trip, the expenses incurred during the trip need to be apportioned between the two properties you have inspected.
• Any expense which contains a private component, such as travelling to inspect a rental property you own but also enjoying a trip away at the same time. This also applies to properties which are not let out to tenants year-round. If you or your family occupy the property or it is left vacant and unavailable for let, expenses incurred during this time cannot be deducted.
There are two timing methods which can be used to calculate the period for which a deduction is claimed; the date paid, or the date incurred. Only one method can be used, as using both could result in a deduction being claimed twice.
Common deductions made on rental property income include:
• Borrowing expenses
• Body corporate fees
• Travel expenses
• Repairs and Maintenance of the rental property
• Capital works expenses
Money borrowed to purchase a rental property or carry out works that will allow rental income to be derived from the property provide an example of deductible borrowing expenses. Any money borrowed for private expenses, or expenses not related to the generation of income, are not deductible.
These included expenses incurred directly as a result of obtaining a loan for the purchase or improvement of a property used to generate rental income. Examples of deductible borrowing expenses might include:
• Title search fees
• Loan establishment fees
• Fees associated with preparing and filing mortgage documentation, this includes fees charged by mortgage brokers and stamp duty applied to the mortgage
• Other fees charged by the lender as part of the loan process, including lender’s mortgage insurance fees, valuation fees, documentation charges etc.
Deductible and Non-Deductible Travel Expenses
When you are required to travel in order to carry out inspections or maintenance on your rental property, or to collect the rent payments or other activities related to obtaining rental income from the property, you may be able to claim a deduction on the travel costs incurred.
In cases where you have engaged in private activities during your travel to or from the rental property, related expenses will need to be apportioned appropriately, as only those directly related to your income from rent are deductible.
There are also some circumstances where travel costs associated with a rental property are not deductible, for example:
• Travel costs incurred when you are collecting rent that is non-commercial, such as rent paid by a family member or friend whom you are letting the property to at a discount.
• If you are making private use of the property, for example travelling to the property and staying there as a holiday.
• Travelling to the property to conduct general repairs or maintenance during a time when it is unoccupied and/or unavailable for rent.
• Diverting your usual route to work or something similar so that you pass by the rental property, in order to check it out or keep an eye on things. This does not have a connection with earning rental income.
Typical expenses included as part of travel related to the management of a rental property include the cost of meals, accommodation, and the transportation (e.g. airfares or fuel costs). You are unable to claim a deduction on the cost of meals if your travel did not involve an overnight stay in the locality of your rental property.
It is a reporting requirement that, when six or more consecutive nights are spent away from your home, a travel diary be kept which lists your activities, places visited, and the duration of travel times and activities. By making notes in your travel diary and affixing the relevant receipts, you have the required evidence to claim deductions on expenses related to earning income from the rental property/s inspected during the travel.
Substantiation records are required to be kept for any car or vehicle-related expenses that you wish to claim as a deduction. There are four methods that may be used to keep the appropriate records, the best method will depend on your individual circumstances. Examples of these substantiation methods include the logbook method.
Claiming Deductions on Body Corporate Fees
Depending on the nature of your rental property, it may or may not be covered by a body corporate or similar entity which charges fees for the day-to-day maintenance and administration of the property. Body corporate fees may be charged to an ‘administration fund’ or other type of fund. Such payments are assessable as payments for the provision of services. Seeing as the body corporate is charging a fee that enables you to derive rental income from the relevant property, these fees or levies may be eligible for deduction claims.
In certain cases, a body corporate entity may request that you pay fees into a fund designated for use in capital expenditure projects. Such levies are not deductible, so be aware of special purpose or designated funds to which you are directed by your body corporate entity. Another circumstance which may limit your ability to claim deductions on body corporate expenses is this; instead of setting up a separate or designated capital expenditure fund, the body corporate may levy funds from their general purpose fund to use as a contribution towards capital expenses. When such payments are made, they constitute a special contribution, which is not deductible.
It is important to note that deductions cannot be claimed for expenses included in body corporate charges, levies, or fees. For example, building insurance, garden maintenance, or building repairs cannot be claimed as deductions if they are included in the body corporate fees you pay. You are able to claim a deduction on the fees paid to a regular body corporate fund, but are unable to claim separately for any expenses covered by the body corporate and paid for through the levy or fees that they charge.
Income Producing Components of Your Rental Property
For taxation purposes, a rental property comprises the building or buildings, land, fixtures, and any separate depreciating assets attached to the property which complement its ability to produce income. Different tax rules apply to different parts of the property, and it can be difficult to work out what is what. Some fixtures or depreciating assets may be assessed under capital gains tax rules, whereas others may constitute capital works. In order to identify what is a depreciating asset, and therefore eligible for relevant expenses related deductions, let’s go through some common examples.
Typical examples of depreciating assets that form part of a rental property include:
• Carpets, linoleum, tiles, and other removable floor coverings
• Internal blinds and window curtains
• Hot water systems.
Claiming the Cost of Depreciation
You may be able to claim a deduction on the cost of depreciation for each separate depreciating asset that comprises your income-producing rental property. In order to claim such deductions, the cost of each asset needs to be determined. The best way to do this is by using the purchase price, which may be evidenced by a receipt.
If you have purchased a rental property that came with such depreciating assets already installed, the purchase contract may have itemized a price for each of the depreciating assets. If this is the case, you can use the price listed for each asset in the purchase contract when claiming deductions.
If you do not have access to the purchase price for a depreciating asset, a valuation needs to be conducted if you are to claim a deduction. It is possible to conduct estimates, but you need to provide evidence which demonstrates that such estimates are reasonable and fair. Obtaining an independent valuation from a valuation practitioner is another way to go, especially if your rental property contains a number of unvalued depreciating assets. When an independent valuation is performed, this is often taken as sufficient evidence that a reasonable value has been ascribed to each depreciating asset.
Claiming the Costs of Construction: Capital Works Deductions
For tax purposes, certain types of construction which enable or enhance your ability to derive income from a rental property are referred to as capital works. You may claim deductions on certain construction expenditure, including:
• Alterations to buildings
• Construction of new buildings or extensions to existing buildings
• Structural improvements to buildings, commenced after February 27 1992
• Capital works which commenced after June 30 1997.
Certain construction or capital works expenditure is specifically excluded for tax purposes, meaning that deductions cannot be claimed for the following types of expenditure:
• The cost of land on which a rental property is built or established
• Capital amount for a loan
• Expenses for plant, though these may be assessed as depreciating assets which can be claimed
• Landscaping expenditure
• Expenditure related to the clearing of land on which the rental property is constructed
For tax purposes, construction expenditure refers to the actual costs incurred when constructing buildings or extensions. If you are selling a rental property, the Income Tax Act specifies that sellers disposing of capital works are required to provide the purchaser with a notice allowing them to calculate any remaining deductions on the relevant capital works. Once received, the purchaser must keep a copy of the capital works notice for five years following their disposal of the depreciating asset/s.
What to Do When the Construction Expenditure is Unknown
If you have purchased a rental property from which you plan to derive income from rent, you may wish to determine the construction expenditure in order to claim relevant deductions if they are still available. In cases where the seller or previous owner is unable to provide the required information, the purchaser may obtain an independent valuation from a qualified practitioner.
In cases where the actual construction expenditure figures are available, you are unable to choose between using those figures and obtaining an independent valuation. The actual figures must be used where they are available.
The following are examples of practitioners qualified to give a valuation on construction expenditure:
• Quantity Surveyors
• Clerk of Works, project organisers who work on significant construction projects
• Builders with experience in the estimation of construction costs for projects of a similar scale
• Supervising architects qualified to approve payments at stages throughout the development of major construction projects.
The following records are required to be kept in relation to capital works and construction expenses:
• Dates on which construction work was commenced and completed
• The specific type of construction performed, used in determining whether or not the construction satisfies the definition of capital works
• Details of the individuals or entities who performed the construction work
• Total expenditure of the construction, note that this is not the purchase price
• A list of dates showing when the property was used to derive income
• Sheets demonstrating the relevant deduction calculations.
If you sell a rental property, keep the above records for five years after the sale. This is important because deductions for capital works can reduce the cost base used to calculate your capital gains tax obligations.
Claiming Expenses for Repairs or Maintenance
For the purpose of claiming a tax deduction, repairs as assessed as the renewal or replacement of a damaged part. In relation to your rental property, this might include the replacement of sections of fencing or guttering following storm damage. Maintenance expenses, on the other hand, are expenses incurred as a result of work carried out to prevent deterioration or to renew existing deterioration. An example of a maintenance expense might be the costs incurred when repainting a rental property.
Some kinds of expenses might intuitively seem to relate to repairs or maintenance, but for tax purposes they are assessed as capital expenses. The following are examples of capital expenses for which deductions cannot be claimed, though they may seem to be related to maintenance and repair:
• Renovations, repairs, improvements and alterations that go beyond the simple restoration of the property to a level of efficient functioning. These are assessed as capital works where they change the nature of the property or asset involved, or if they add something new to the property.
• Repairs or maintenance works performed at the same time as improvements or renovations are being carried out, meaning that the costs cannot be separated between what is an improvement or what is a repair.
• Replacement of items regarded as separate to the property itself, typically fixtures such as a complete set of guttering, an entire fence, and cupboards and cabinets.
• Repairs carried out soon after the property was acquired, which remedy damage, defects, or deterioration that existed on the date the property was acquired.
• Repairs or maintenance works carried out when the property is not producing income from rent, or if the property was not producing income from rent for the duration of the income year in which you incurred the cost of these repairs or maintenance works.
Note that in some cases where you are unable to claim a deduction on capital expenses, you may instead be eligible for a deduction on decline in value for capital works deductions or depreciating assets.
It should also be noted that payments made to yourself in return for managing or maintaining a rental property are not deductible, nor are payments made to family members or friends. Payments made to agents may be deductible, where you use an agent to manage a rental property instead of performing checks and maintenance yourself.
Key Points When Lodging Your Tax Return and Rental Property Schedule
By keeping records of all the above expenses and income elements that influence your tax position, and having a summary of these records on hand at tax time, you should be able to quickly and easily complete your income tax return and the rental property schedule included in it with minimal fuss.
If you own more than property from which you derive income from rent, you need to complete a separate rental property schedule for each individual property. It may be tempting to list all the information in the section labeled Sundry rental expenses, but this may cost you more time later on should the ATO seek clarification. The rental property schedule contains separate labels for different kinds of income and expenses, so use your records to list the information in the appropriately labeled section and you will have minimized the chance of a dispute occurring.
For those that prefer to leave their tax return to a financial professional, they can rest assured that their accountant is complying with the above, thus minimizing the chance of follow up action by the ATO. If you are completing your tax return yourself, taking the time to correctly complete the rental property schedule and placing information under the correct labels will help you to avoid follow up action.
In the case that your expenses exceed the amount of rental income you have received from a property, but you also receive other taxable income such as a salary or wages on which your employer is required to withhold tax, you may be able to claim a tax refund on some of the withheld amount. The following options could suit a rental property owner in this situation:
• Lodge your income tax return and receive a tax refund later in the year
• If it is the start of the year, you may be able to lodge a withholding variation to the ATO. A withholding variation, if approved, would result in your employer withholding less of your income as taxation to reflect your losses incurred through the rental property.
In the event that you have incurred an overall loss, it is advisable that you report your losses in full and retain relevant records until the losses are recouped, and then for five years after the date on which you break even again.
If you are an Australian resident that receives income from a rental property located outside Australia, you are required to list this income at Label 20 on your individual tax return. Note that for tax purposes, income is ‘received’ even if it is held oversees and not able to be accessed by you in Australia.
It is also important to remember that the ATO requires you to list any foreign income or capital gains even if they have been taxed in the country of origin. There is an offset available for tax paid overseas known as the foreign income tax offset, this offset can be found at label 20 of your supplement tax return.
When reporting income derived outside Australia, or in currency besides the Australian dollar, all values and amounts need to be converted into Australian dollars.
Pay As You Go (PAYG) Options
The ATO operates a Pay As You Go system referred to as PAYG, which is available to businesses and individuals alike. Registering for the PAYG system allows you to make instalment payments towards your total income tax burden. The system can be accessed and registered through the ATO’s online system. Once you register, the PAYG activity page will indicate that you are paying a rate of nil towards your tax liability. You can increase this rate as required, meaning that paid instalments will be made regularly, therefore reducing your tax bill and preventing you from having to pay a large lump sum at tax time.
Contact Kingston & Knight Accountants today on 1800 283 481 to learn more about our Melbourne accounting services, or email us at firstname.lastname@example.org.