ATO will look closely if it knocks on your rental property door
Author: By Max Newnham
Date: February 2 2004
Publication: The Age

The property boom of the past few years means property values have increased at alarming rates. The number of taxpayers involved in the rental property market has also grown at a rate that appears to have worried the Tax Office. Late last year it notified tax agents of the continuing rental audit program of their clients that tries to ensure taxpayers do not overclaim rental deductions.

Due to the complexity of the Tax Act, there are often amounts spent on a property that, if not treated correctly, could cause audit problems. These include incorrectly claiming a deduction for costs relating to the buying of a property, overclaiming interest where a loan includes amounts borrowed for both private and investment purposes, incorrect asset values being placed on depreciable fixtures and fittings, borrowing expenses incorrectly claimed, and travel expenses being overclaimed.

Under the Income Tax Act, capital costs associated with buying a property must be distinguished from income costs. Capital costs are not deductible in the year they are incurred while income costs are claimable in full. Examples of deductible income costs include interest, insurance, rates, and agents' fees.

As a rule, amounts spent before a property is rented are capital costs. Examples of these include stamp duty, legal fees, the costs incurred in finding the property such as travel or agents' fees, and repair costs to put the property into a condition where it can be rented.

These are added to the purchase cost and used to decrease any capital gain. They cannot be used to increase a loss on negative gearing.

Some costs of repairs will also be classed as capital even when they are paid for after a property has started earning income.

In these cases, if the problem existed at the time of purchase but the repair took place after tenants moved in, the repair cost is classed as capital. An example would be a house bought with a rusty roof and a few small leaks. If the roof is repaired or replaced after being rented, the costs are not deductible and must be added to the cost of the property.

The task of calculating how much interest is tax deductible is made harder when there is one loan made up of two different borrowings. This can often occur when a home loan has been substantially paid off and the loan is extended to provide funds to buy a rental property. In this situation the tax-deductible interest component is the percentage of the interest that equates to the percentage the investment loan makes up of the total loan. For example, on a loan of $250,000 with an investment loan amount of $200,000, 80 per cent of the interest is tax deductible.

Problems can also arise with a loan made up of two components when large amounts of principal are paid off the loan. These capital repayments must be fairly apportioned between both loan amounts.

What some people try to do is only reduce the private loan balance, thus increasing the tax-deductible percentage for the investment loan.

The Tax Office will not accept this in an audit. By having two loans, all principal repayments can be made off the home loan and interest-only payments made on the investment loan.

The non-tax-deductible interest payments will reduce more rapidly while the tax-effective interest stays the same. This means that if a tax audit takes place there will be one less problem that may arise.