Tax benefits of residential investment property

Investment in residential property has long been a popular way for Australians to build wealth and diversify their assets. The potential tax advantages that can result from a well-managed property investment are one of the main benefits.

Residential properties are premises that can be occupied as a home: the definition includes houses and apartments but not vacant landⁱ. Negative gearing, leveraging, tax deductions and depreciation allowances are some of the major advantages you can expect if you're looking to invest in the residential property market. While there are many potential tax benefits of property investment, there are also some pitfalls to avoid as a residential investment property owner.

Negative gearing

Negative gearing occurs when the income generated from an investment is less than the cost of owning and managing it. This means the rental income you receive is less than the expenses you incur in relation to the property. You can help to reduce the amount of personal income tax you pay under this model because while investors are required to pay tax on income received from investment property, their taxable income can be offset against income from other sources. In the case of residential investment properties, this may result in a reduction in personal income tax.

In the above circumstance there are tax advantages, but the investment is making a loss. Most investors also hope to benefit from a capital gain: the value of the property increasingⁱⁱ. You may also want to note that while you are required to report your capital gains as income for tax purposesⁱⁱⁱ, you can also report your capital 'losses', such as when the investment property is sold for less than its original purchase price), as a reduction on your return.

Leveraging your investment

Leveraging occurs when you use debt to fund an investment. If you take out a loan to purchase a residential investment property, you can offset interest on the loan and most property expenses against rental income, for tax purposesⁱⁱ.

Tax deductions can be claimed for many of the expenses related to your residential investment property. However, deductions can generally only be claimed for the period your property was rented or available for rent. Examples of claimable expenses include^iv:

• advertising for tenants
• agent fees and commissions
• bank charges
• body corporate fees and charges
• cleaning and gardening expenses
• council rates, land tax and strata fees
• building and landlord insurance
• interest payments and legal expenses
• repairs and maintenance costs
• water charges
• depreciation of fixtures and fittings

The above list is not exhaustive, and it's best to seek expert advice from a tax agent. Keep in mind that there are also expenses for which you are not able to claim deductions, some of which include:

• acquisition and disposal costs of the property
• expenses which were not incurred by you, such as electricity charges paid by your tenants
• expenses not related to the rental of a property, e.g. expenses connected to your own use of a holiday home
• borrowing expenses or interest on the portion of the loan you use for private purposes, such as buying a new car^v.

Depreciation allowances

As a residential investment property owner, you can claim depreciation for the wear and tear of fixtures and fittings. This involves writing-off the cost of the item over a set number of years, or the 'effective life' of the asset. The Australian Taxation Office (ATO) sets out a comprehensive guide regarding what it considers to be appropriate periods of time for a wide range of items^vi. It is important to note that there are different rates of deductibles attached to new and existing buildings and financial advice should be sought in relation to the applicable rates for the type of residential investment property held.

Risks and pitfalls

While the potential for wealth accumulation from tax benefits through residential property investment are attractive, it's important to be aware of the risks involved. For example, if the property price declines, the potential tax implication is that your losses might exceed your profits from other sources resulting in a net loss. Similarly, if the property is vacant or tenants do not pay the rent, your financial situation will be affected.

There is also a liquidity risk to investing in property; if your property doesn't have a buyer when you're ready to sell it, you'll have to hold on to the investment or potentially reduce the purchase price to attract a buyer^vii.

Insurance is a vital part of protecting your investment. The Australian Securities and Investment Commission recommends that you organise building insurance covering the full value of your property to protect you during unforeseen circumstances such as a house fire. Landlord insurance is also available to cover property damage by tenants, loss of rent, building damage, and moreⁱⁱ.

If you're looking to make a property investment, start with a clear plan and strategy. To maximise the tax benefits available from your investment, seek independent advice from qualified experts such as accountants, financiers and quantity surveyors before you purchase a property.