Misconceptions of Property Investors - Part II

...continued from this thread.

“I get it all back in tax”

Unfortunately this is a concept that seems to rear its head over and over because of a lack of understanding of how the tax system actually works. When something is tax deductible, it means you pay for that item with pre-tax dollars, not post-tax dollars. Given that most people pay for things with income they receive from their PAYG salary, which has already been taxed, an adjustment is required at the end of the financial year to essentially reverse the situation. It is reversed by providing you back the portion of tax you shouldn’t have paid on the equivalent income amount that the item costs.

For example, if you earn $100 and we assume a simple tax rate of 30%, you will pay $30 in tax and be given $70 by your employer. If you then buy something for $100 that is an allowable tax deduction, they reverse this by giving you back that $30 at tax time. The lesson here is that you are still $70 out of pocket for the item that costs $100! Even if you’re on the highest margin tax rate, you will still be out of pocket for just over 50% of the amount for any tax deductible item.

What this means is that higher income earners on the highest marginal tax rate derive a greater dollar benefit on the individual deduction. It should be noted though for fairness that the higher income earner will still pay a greater amount of net tax on the same rental income post deduction and that the benefit received versus the total net tax paid (on the investment income expressed as a percentage) actually decreases until the highest marginal tax rate is reached.

No matter what your income, even though you receive “tax assistance” to fund the item, you should still consider any expenditures carefully in the context of cash flow as it will affect your bottom line.

“All of my maintenance is a tax deduction”

Although it would be nice to have anything you spent on your property to count as an immediate tax deduction, unfortunately the ATO does not see it this way. Generally speaking, the rule when it comes to maintenance on an investment property is that anything you spend to return the item to its original condition is an immediate deduction in that financial year, whilst most things that improve the property are able to be depreciated.

To illustrate with a simple example, if an air conditioner breaks down in your property and you have a technician repair that same air conditioner, the cost of that maintenance will be deductible. If the technician is unable to fix it or you decide to replace it in its entirety, the cost of a new air conditioner becomes a depreciable tax deduction and is counted towards the Division 40 Plant and Equipment discussed earlier in part I of this thread.

Sometimes, it’s actually better to simply replace the item and depreciate it. Not only will the depreciation deduction be reasonable in that year anyway, but it may save you money on future maintenance if it’s an aging item. As a further bonus, you will also be able to 'scrap' the old air conditioner by writing off the residual value apportioned to it in that tax year. Also, Division 40 allowances do not affect the cost base for CGT reasons.

You must be careful though as not all items that are perceived as immediately deductible maintenance fall into that category. Painting your house is a good example. If you paint a few small sections where the paint is flaking off, this would be an immediate deduction. However, if you paint the interior of the house in its entirety as part of a renovation to improve the property or as part of initial repairs after purchase, this actually forms part of the building allowance. What this also means is that it may have CGT implications at sale time. It’s not all bad though as you are still entitled to yearly deductible amounts in the meantime and a repaint will also add value to your property and usually increase the rental return too.

Overall, you should check with your accountant to make sure whatever you’re spending is attributed to the right class of deduction as you don’t want to be making adjustments (and possibly paying penalties) if you are audited by the ATO at a later date.

To continued in the final part III...

- Andrew

 

Great read Andrew. Thanks for sharing.
I used to think like that first point, getting a tax return is nice but I suppose its easy to forget its not all that was withheld, unless the taxable income below the $18k threshold.

 

It is interesting your comment about painting inside and/or outside sometimes being not immediately deductable
I have probably painted all my buildings three times by now and have claimed the expense as being immediately deductable.
For several years i actually employed staff to do the painting. (It was not my best decision ...found it better to use contractors!)

 

It comes down to the definition of repair and whether it is needed. If the paint is flaking off across the whole house on every section you paint then it would be a deduction. However if you paint it as part of renovation to improve the quality of the paint when it wasn't damaged, it's capital. It is a grey area!

The same applies for flooring. Generally the same applies however there are TRs that have set some precedent otherwise! See here as an example.

At the end of the day, check with your accountant before you do anything and have a comprehensive reason to justify it to the ATO should you get audited. If you or your accountant are unsure, the best protection is to apply to the ATO for a PBR prior to completing any works.

- Andrew

 

I have an IP that the paint is a bit weary. Inside and out. Goes beyond what I'd call "fair wear and tear". Tenant has 3 teenage kids, 2 dogs, and several reptiles (all on lease).

Now in 6 months time when they vacate at end of lease, I'll be painting inside and out as the interior walls are chipped and marked (particularly wall edges) and parts of the exterior render has been chipped (don't ask me how). Replacing all carpets as they are wool and heavily stained. It looks like I'm also up for kitchen benchtops as the tenant is complaining of circular stains in the laminex (which are the exact same size as a hot pan off the stove ).

So from the OP I'm gathering that all these items are deemed as Improvements and Depreciable over 5 years is it? Even though they shall all be replacing back to original condition?

I shall also be installing an aircon unit. This is clearly an outright Improvement over standard.

 

Still, I am pretty happy when it comes to tax time thought. It's like an early Christmas to me and I do acknowledge the merit of being aware that it's a fallacy to think everything is tax deuctible when it is a depreciation. I see time being a friend to me because with it comes with the rental increases over time, less mainteance fees (hopefully due to it already being fixed), increase in capital growth and increased salary (hopefully!).

 

Again, it really falls under whether it is a repair or improvement. If the paint is deteriorated and damaged throughout, you may be able to claim it as a deduction. If it's part of an initial purchase, or painting to to improve the property, then it's not. I will make a small amendment above to clarify. As always, check with your accountant and also, your depreciation company! They are very good and often more experienced with rental property deductions than your accountant!

 

When people say 'Oh it's a tax deduxtion' and act like it doesn't cost anything, I reply 'hey can you give me $1000, I'll give you an invoice. It's a tax deduction. Deal? "

I've never had anyone take me up on it

 

@Sonamic surely some of that damage, particularly the benchtops, goes past wear and tear and would be a bond or maybe insurance claim?

 

Yes. That's what I'm thinking to. I know for a fact that the benchtops were mint condition before they moved in as 1. I inspected the entire house personally before Opens (had to replace a knob in the main bathroom drawers and check the curtains that the previous tenant changed out were up to standard) and 2. The house was only 10 years old. How long should a kitchen last?

PM has Entry Report photographs, so the proof is in the pudding. Either way I'm putting aside 20-25k just in case.

 

great threads and post - question

when should you conduct a depreciation schedule for a property which upon settlement requires cosmetic renovations - touch up of paint work, minor maintenance with doors/windows, installation of new hot water system, installation of new air conditioners?

should you conduct a before and after depreciation schedule (in effect x2 schedules)?

 

@Sonamic if it's well looked after much longer than that. Either way, burn marks in a benchtop are not usually wear and tear, but as you said, if the inspections have been done and entry report has no evidence of it then there's your proof. I'm sure some other PMs on here may have better knowledge of what's normal wear and tear and what's not... @D.T.

 

@Hwangers I use BMT and they let me update my initial one for free after some work was done, just sent in photos and description of work done

 

nice! so you obtained dep schedule on settlement, conducted renos and then went back to them to update the initial dep schedule?

 

@Hwangers yeah for me it was actually changing an unfurnished property to furnished so the initial schedule had no furniture included and once it became furnished I emailed them a list and photos of all the new furniture and they sent me back an updated report with furniture included which I just passed onto my accountant. Was a pretty simple process

 

@Hwangers there's really no difference in waiting anyways until you have the reno's done, nothing happens till tax time anyways

 

Yeah, cause they are only getting a paper invoice and everyone knows that is not worth a grand or the paper it is written on

 

You should speak to a QS first to determine the exact requirements as you will be able to 'scrap' residual values of things like old hot water systems which you now technically own. These will be built into the first year's figures in addition to the new write down value of the installed assets.

I am not a QS but my understanding is that to extract maximum value you would be better to have the report done first and then just submit your evidence (receipts and photos) of the new works completed that they will use to amend the report, usually for a small fee. I guess it could be done the other way around but it's much easier to quantify the value of new works (given you know exactly how much you're spending) than old assets.

If you're up front with them and request the inspection first, then delay the report until after works are complete, they may just prepare the single report from the outset building in both the scrapped values and the new write down values of the installed assets. This could possibly save you money.

I'm sure every depreciation company works a little differently so it's best to speak to you you're planning to use first to check with them. The company I now use exclusively are brilliant at being flexible which is also part of the reason I use them!

- Andrew

 

I use BMT exclusively for all my QS work. So one works are completed I'll just email invoices and pix to them, they can update that properties file, make the necessary adjustments to the Schedule and send it direct to my accountant. Job done.

 

That's usually the case but I think the question relates more to works completed around settlement when you don't already have a schedule complete. It's a bit more of a juggling act at that stage of the game.