When tax time comes, property owners need to go over their financial activity for the year with a fine-tooth-comb.
If checklists, statements and receipts are the hunting ground, then verifiable tax deductions are the prize. The stakes are high because the investor with the most tax deductions wins the biggest (or most favourable) tax return.
Inevitably there are numerous questions that pop up in the area of tax deductions, and one of the greyer areas is the topic of refinancing. We spoke to property tax expert, Shukri Barbara, of Property Tax Specialists to help us get our facts straight.
Who is eligible for tax deductions on their property and what are they?
According to Mr Barbara, 'The basic rule of the tax law is that tax deductions are only eligible on assets that are earning an income. Your main residence does not generate an income and therefore, no tax deductions are available on the interest or expenses associated with maintaining that property. For an investment property, however, you are charging rent and therefore generating income. This income is assessed and as a result many expenses are tax deductible.'
Tax deductions that property investors can claim are divided into two categories: those that can be claimed immediately and those that can be claimed over a number of years.
Items that can be claimed immediately include, but are not limited to, property management and maintenance expenses, rates and taxes, repairs and maintenance, interest and loan account-keeping fees and administration expenses.
Items that are deductible over a number of years include borrowing expenses (over five years) and the depreciation on the building construction and the value of particular assets.
What tax deductions are available as a result of refinancing specifically?
When people refinance they are essentially terminating one loan and starting another. The costs involved in setting up a loan and exiting it are tax-deductible when it’s for an investment property.
There are two main areas of tax deductions that can be claimed when you are refinancing; the initial borrowing costs and/or the exit fees and penalties.
Barbara explains, 'When an investor initially buys a property, they have a number of borrowing expenses that they have to pay. While they are much less than in previous years, the amount depends on the type of loan (whether it’s a low doc or no doc) and includes loan application fees, legal fees, Lender’s Mortgage Insurance, stamp duty and loan registration costs. During the first five years of that property ownership, investors can claim those borrowing expenses back incrementally. If they sell the property or refinance it within those first five years, the investment property owner can claim the remaining tax deductions straight away.'
- Tom chose to refinance his investment property three years after buying it because he wanted to change banks and get a more competitive interest rate. As a result, he can claim the remaining tax deductions on the borrowing costs that he would have realised in year four and five.
- Cathy has owned an investment property with a fixed rate loan for two years. She has hit a tight financial spot and needs to refinance. Because Cathy is terminating her mortgage within the set fixed interest rate period, she has to pay a penalty to her bank. All exit fees and penalties that Cathy has to pay are considered a tax deduction.
A closer look at some refinancing situations:
People refinance for many different reasons and in all sorts of ways. These are a few of the refinancing circumstances, and their resulting tax considerations.
This is a very clean form of refinancing and is primarily based around accessing lower interest rates. The case studies of Tom and Cathy above refer to this type of refinancing. The tax deductions available are the remaining borrowing costs that were spread over five years and the exit fees and penalties that result from a fixed rate loan.
Using equity from your main residence to buy an investment property.
More often than not, refinancing isn’t simply about switching to a more competitive interest rate. Many people look to refinance their main residence home loan in order to access their equity and invest in a rental property. This is done with the aim of generating wealth. 'In this case, interest will be deductible because the loan principal was applied to acquire income-generating property,' says Barbara.
Turning the main residence into an investment property and buying a new family home.
In some cases, people have paid off their main residence and are ready to move on, but choose to rent the property out instead of selling it. In order to afford their new family home, they access equity from their paid-off home. In this case, there is no tax benefit because the now-rental property is already paid off and the interest on the equity amount is not going towards an income-producing asset.
How can investors maximise tax deductions on interest?
Shukri Barbara has this important warning for anyone looking at a new home loan: 'Investors need to be mindful of how they structure their mortgage in the first place — even for their principal place of residence.' His advice? 'Use an offset account.'
'An offset loan is based on two parts — the loan facility and the deposit account. It is best to maximise your loan and use the deposit account primarily,' Barbara said. Instead of paying down the principal of the loan, keep the money in the deposit account. You cannot claim a tax deduction on repayments made towards the principal of an investment property loan — only the interest portion of repayments is tax deductible.
In the case of the third refinancing situation we investigated above, if the owner had used an offset account, the amount of the loan would not have changed and would not have been ‘paid off’. When they went to purchase their new family home with the equity, the amount in the deposit side would have lowered and the loan would have started accruing interest again. This interest would have been a tax deduction.
Using an offset account is important because you don’t know what the future holds. As Barbara puts it, 'The test of deductibility is how you apply the funds. In the simplest terms, if you apply the funds to an asset-generating account, the amount is deductible. If you put it on the principal amount and then redraw an amount that you have already paid off, it is not deductible.'
How do investors claim tax deductions when refinancing?
In order to access all of the tax deductions that you are due as a property investor, it is important to maintain records and keep documentation of all bank statements and receipts. Barbara’s company, Property Tax Specialists provides a checklist for their clients to make use of during the year to keep on top of what is important to keep, what to keep an eye out for and to remind you about what tax deductions are available.
In the case of refinancing, your bank will be able to provide you with a statement of costs that you can give to your accountant. If you are unsure about what tax deductions you are eligible for or want to ensure you maximise your return, Barbara advises using a property tax professional, 'We can work with you to structure your property investments to minimise tax, maximise your returns and protect your assets while keeping the ATO happy.'
'At the end of the day,' Mr Barbara cautions, 'you have to remember why you became a property investor. It is for the economic benefit rather than the tax deductions; they are a just a bonus on the side.'
Need more information about your property tax situation?
You can get into contact with Shukri to get advice regarding your property tax issues by filling out the form below.
The Property Tax Specialists are an award-winning leader in the Australian taxation field, with strengths in accounting, marketing and business. They can help with matters of asset protection, property investing, accounting and taxation, including capital gains tax enquiries. Fill out this form with your query to get into contact with an expert from Property Tax Specialists today.
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Rates last updated January 20th, 2017.
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