ATO gets tough on dodgy deductions

Don't get deductions for maintenance and capital works confused.

The Australian Taxation Office has made no secret of its plans to get tough on dodgy deductions related to investment property.

Last year taxpayers declared total rental income of $15.2 billion and claimed rental deductions of $17.8 billion. So while rental income was up by about 12 per cent on the previous year, rental deductions claimed were up by 19.5 per cent. If you're one of the 1.4 million Australians who owns a rental property, the onus is on you to find out what you can legitimately claim.

Paul Drum, a senior tax counsel with CPA Australia, say this task has become easier since the ATO began offering its rulings in easy-read guides. (Its Rental Properties booklet can be obtained at ato.gov.auor phone 1300 720 092).

Drum says rental property has been under close review since the mid 1990s and he describes the new ATO approach as "following up rather than hiding behind bushes and catching people". "Don't assume that because you spend the money it's going to be deductible in the year you incur the expense," he says.

This dividing line between two distinct categories of rental property expenses is one many investors still trip over. Falling foul of the tax office can occur if you confuse expenses that are deductible in the year they were incurred (such as council rates, insurance and loan interest) and expenses which are only deductible over a number of years (such as borrowing costs and deductions for the decline in value of depreciating assets).

For instance, one of the ATO's bugbears is people claiming as immediate deductions the costs to repair damage, defects or deterioration that existed when they purchased the property. These costs are considered capital expenditure and should be claimed as capital works deductions over either 25 or 40 years, depending on when they were carried out. If you buy a "renovator's delight" expecting to do it up, rent it out and claim the initial renovation costs as repair and maintenance costs, you're out of luck.

Michael Dirkis, senior tax counsel with the Taxation Institute of Australia, says renovations should not be passed off as repairs. "Repairs are about restoring something to its original condition, not about adding improvements," he says.

According to the ATO, the cost of improvements such as remodelling bathrooms or kitchens are capital improvements and should be claimed as capital works deductions.

Andrew Gardiner, senior tax manager with the National Tax and Accountants' Association, advises trying to come to grips, too, with the difference between depreciating versus deductible assets. A list of more than 230 residential property items - identifying whether they are depreciating assets eligible for a decline in value deduction or as assets eligible for a capital works deduction - is in the Rental Properties booklet.

Further, Dirkis says, watch out if you're planning on claiming the full cost of a trip to the Gold Coast to inspect your two-bedder rental with views of the beach. The ATO will want to know the dominant purpose of your trip - and if it was to meet the real estate agent for a casual five-minute walk-through, that just won't cut it. On the other hand, if you're up there solely to carry out necessary maintenance, you may have a claim.

Also, when you combine an inspection visit with another private purpose, such as a holiday, you can claim only the travel costs related to the property inspection.

Another ATO no-no is the practice of incorrectly claiming deductions when properties are available for rent only for part of the year. If a holiday home or unit is used by you free of charge for part of the year, you are not entitled to a deduction for costs incurred during those periods.

Equally, if you rent the property out for only one or two months a year, you'll need to claim pro-rata expenses, rather than claiming 12 months' worth, Drum says.

If the holiday home sits empty for a time, you can still claim a deduction for costs when a property isn't rented so long as it's available to rent.

Not declaring income from your investment property is another mistake.

The ATO warns it obtains information from state revenue offices on investment properties, holiday houses and units "to help us identify relevant taxpayers".

Drum says owners should beware falling into the trap of failing to declare any capital gain when the investment property is sold. "This can be the result of an honest mistake, or intentional disregard," he says.

Given that one of the most useful tax deductions on an investment property is the interest on your loan, it's worth number-crunching the effect of the new tax rates and thresholds coming into effect from July 1.

Nicholas Gruen, chief executive officer of discount mortgage broker Peach Home Loans, says landlords could be thousands of dollars better off by paying interest on their borrowings in advance.

"Many astute investors regularly pay next year's loan interest in advance to claim interest payments on investment loans in the current financial year, but this year there are two one-off factors that could make it additionally lucrative, potentially saving investors several thousand dollars," he says.

Now that the likelihood of another rate rise has increased, fixing and paying interest at current rates can lock an investor in at a more favourable rate.

"And with tax reductions on the way in July, by paying in advance you maximise your interest deductions against higher tax rates and minimise it when tax is lower," he says. "In any year, pulling forward your tax refund allows you to effectively claim two years' deductions in one year [allowing you to] get next year's refund a year early.

"The total amount of tax refunds generally will stay the same, but you'll get them sooner, so it's effectively a free loan from the government.

"Paying interest in advance can be particularly advantageous if the tax rate you'll pay next year is lower than this [ year, as] is likely to be the case if you earn over $63,000 [or] if you think your taxable income will fall next year if you're going on a break or going part-time or having a child."

31st May 2006

Source: SMH