Four Common Mistakes that Landlords Make on their Tax Returns

Congratulations! You’re now one of millions of Australians who own a residential investment property. While you believe that it will be a good investment (after all, to quote Will Rogers they ain’t making any more of the stuff) you are confused by all the tax rules surrounding what can and can’t be claimed as a deduction.

Don’t worry, you’ve come to the right place. All you need to do is remember – ‘Don’t do what Donny Don’t does!’

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1. Interest

Donny Don’t borrowed $600,000 from the bank, putting up a commercial property as collateral. He uses $500,000 to purchase, with his wife, a bungalow on Hamilton Island that he intends to rent out, and the remaining $100,000 on a Porsche he always wanted. Donny figures that all his interest payments will be deductible since the majority of the loan is for an income-producing asset and he is using an income-producing property as security.

The deductibility of interest typically comes down to your reason for borrowing the money and how you actually use the borrowed funds. Therefore, if Donny borrows money to purchase a property that earns him assessable rental income he can claim a deduction for the interest on the loan repayments. There are, however, a few things Donny should be aware of.

– Where a loan is used partly to purchase an investment and partly to buy a personal asset (such as a new car) you cannot claim a full deduction for all the interest.  Instead you must apportion the interest and not claim a deduction for the part that relates to your private purchase. Similarly, if Donny was to use the bungalow in December and January each year the asset would have a dual purpose and an apportionment of the interest would be appropriate.

– The security for a loan does not affect the deductibility of the interest. Using a business asset as collateral on a personal loan will not make that loan any more deductible. Conversely, using the family home as security for a loan to purchase an investment property does not cause the interest on this loan to lose any of its deductible character.

–  A deduction for interest can be claimed even where no tenant has yet been found provided you make continuing efforts in pursuit of assessable income. This could be demonstrated by listing the property with an agent for a reasonable price. However, if the efforts to find a tenant become truly dormant then the interest will not be deductible, even if you plan to revive your efforts at a later date.

2. Apportioning deductions

Whilst Donny is a partner at a successful law firm, his wife Danny (short for Danielle) earns far less income as a substitute teacher. Their property is negatively geared and Donny and Danny decide to include more of the net loss in his tax return since, at his higher marginal tax rate, the deduction will save more tax. They own the property as joint tenants. Unfortunately this is not permitted;

– Other than in very limited circumstances, where a property is owned by joint tenants it is not possible to share profits or losses in any other way other than equally between them. This is true even if there is an agreement between the two parties or if one owner funds a greater share of the outgoings.

– Had they purchased the property as tenants ion common Donny and Danny could have held different legal interests and should have reported income and claimed deductions in proportion to those legal interests.

3. Repairs

When Donny purchased the bungalow the floors were badly damaged. Donny didn’t mind though since it reduced the purchase price and he figured that he could claim a deduction for the cost of replacing them with a more durable, higher-quality flooring. Unfortunately, Donny is mistaken.

– Repairs to defects that existed at the time you purchased a property are not deductible, (these are known as initial repairs) even if you carry out the work after the property becomes income-producing. These costs form part of the cost base for capital gains tax purposes.

– While repairs are generally deductible, improvements are not. A repair involves restoring a thing to a condition it formerly had without changing its character. This would include work done (e.g. painting) to prevent defects for developing. However, where the function of the item is improved the cost is not deductible. Often a repair and an improvement occur together. In these circumstances no deduction can be claimed for the ‘notional repair’ where it is not separately identifiable

4. Travel expenses

Donny chose to buy in Hamilton Island because it is his favourite place to holiday. He figures that now the family (Danny and their two children) can holiday there each year and he can claim a tax deduction for the trip since they will pop in and check the property.

Many travel expenses relating to a rental property are likely to be deductible as they are incurred in gaining assessable income. These would include trips to prepare a property for new tenants, to carry out repairs (not initial repairs) or to visit the estate agent. Unfortunately however, Donny is incorrect

– Only a reasonable portion of accommodation costs could be claimed. The portion relating to the children’s room and the days where the bungalow was not inspected is private and non-deductible.

– A deduction for airfares can only be claimed if the main purpose of the trip is for a tax-deductible reason. If the main reason is to have a holiday then no part of the cost can be claimed. Only the costs of getting to property directly (e.g. a taxi fare) could be deducted.

Disclaimer

This article is designed to briefly highlight some of the issues that a landlord, particularly a landlord who holds a residential property as a capital asset for income producing purposes, may need to consider when preparing their tax return.

It does not seek to be a comprehensive or definitive reference for all tax payers. It is important to remember that everybody’s situation is different and what is mentioned in this blog may not apply to you. I urge you to seek professional advice that is tailored to your circumstances.

Please ensure that you also read the full disclaimer on my ‘welcome’ post.