How you manage your tax obligations can have a big impact on the profitability of your property portfolio. Get this right and you minimise your annual tax bill and maximise your regular rental returns. Get this wrong and you could end up paying more and possibly even put your portfolio growth at risk.
Here we take a closer look at a few of the main tax considerations property investors need to think about. We will look at what they involve and how they can affect your return on investment. We will also share our advice on optimising your tax obligations.
Positive v negative gearing
While many consider this more of an investment strategy, how you gear your portfolio has significant tax implications. Put simply, positively geared properties add to your taxable income, so could result in a higher tax bill. Whereas negatively geared properties cost you money, so reduce your taxable income and, by extension, your yearly obligations.
Negative gearing – choosing properties that do not produce enough income to cover their expenses – is the more popular approach. Many investors see it as a great way to reduce their annual tax bill, while still accruing capital growth. Also, negatively geared properties are usually more affordable, making it easier to get into the market sooner.
That said, negative gearing largely depends on capital growth to deliver a return, and this is never guaranteed. How much growth is needed also increases over time, as you steadily invest more and more into the property. And, if you cannot afford to continue covering the additional expenses, you may be forced to sell, possibly at a loss.
While this will be partially offset by the ongoing tax benefit, this really depends on your other income sources. For example, if you earn over $180k p.a., you could save 45c on every dollar you are out of pocket. However, if you only earn $80k p.a., you will only get 32.5 cents on every dollar back.
As such, we generally recommend investors focus on positively geared properties. While this will increase the amount of tax you need to pay, you will not be regularly out of pocket. The extra income produced can also be put toward additional investments, further accelerating the growth of your portfolio.
Capital gains tax
For tax purposes, any profit you make from the sale of an investment property is also treated as income. This means that, if you sell a property for more than it cost to buy, the gain will be taxed. While this will increase how much tax you need to pay, there are ways to minimise the amount.
For example, if you own the property for 12 months or more, your capital gains will be discounted by 50%. This means that, if you own a property for 9 months and make $200,000, the whole amount would be taxed. However, if you own a property for 5 years and make $200,000, you only pay tax on $100,000.
Importantly, Capital Gains Tax (CGT) is calculated by adding any taxable gains to your income for that financial year. The amount of tax you need to pay is then calculated based on your total taxable income for the year. As such, it is possible to use expenses and losses to offset your gains and reduce your total tax bill.
If you sell an investment property for less than it cost you, this loss can also help offset capital gains. In fact, investors are allowed to carry forward such capital losses to offset gains made in future financial years. This means that you can effectively bank your losses and use them when they will deliver the biggest financial benefit.
In a real win for investors, the Australian tax system acknowledges that properties experience wear and tear over time. What’s more, you can claim this gradual decline in value – or “depreciation” – as an expense. This means it can help offset the income you receive and reduce your annual tax obligation.
To take advantage of this, you will need to engage a qualified quantity surveyor to prepare a depreciation schedule. This will set out the expected lifespan of key assets and the resulting deductions you can claim each financial year.
Want to discuss this further?
If you would like more information on the tax implications of your property portfolio, Search Party Property can help. While we are not tax professionals, we have significant experience managing the tax obligations associated with property investment. We also work with a network of tax experts that we can connect you with, for further support.