How does investment property tax work?

How is rental income taxed on an investment property?

The ATO recognises the rental income you receive from your investment property as part of your assessable taxable income. You need to declare all your rental-related income on your personal tax return, and you will be taxed at the same rate as your marginal tax rate for that year. 

As defined by the ATO rental properties also include, ‘part or all of your home through the sharing economy or the renting of your holiday home’.

Let’s now understand what gearing is in the context of property, and the difference between being positive and negative gearing.

What is the difference between positive and negative gearing?

Although it sounds technical, gearing simply refers to the act of borrowing money - using a home loan - to buy an investment property. You can however be positively or negatively geared, which each have very different implications for your investment strategy and financial circumstances. 

If you are negatively geared, the income from your investment property does not offset all the outgoings or expenses related to it - so you are making a loss. This means you will have to fund the monthly or annual shortfall yourself. This is also known as negative cash flow. In contrast, positive gearing is when the rental income from your investment property generates more income than all the expenses (before tax) - so you are making a profit. This is also called positive cash flow.

Read our Guide to Negative Gearing

Let’s now look at your tax implications if you sell your investment property. 

What is capital gains tax?

You need to understand the implications of capital gains tax (CGT) if you sell your rental property and make a profit. CGT is a government tax on any profit you get from the sale of an asset, like an investment property. 

It is calculated by subtracting the cost involved in owning your property from the proceeds of the sale. The amount of capital gains tax you pay depends on two factors, your marginal tax rate and the amount of gain or profit you earned from the sale of your investment property.

Capital gains tax is not taxed separately in Australia, so there is no specific rate of tax applied. Instead the gain - or profit - is added to your overall income for the tax year, so your final tax rate will depend on your personal marginal tax rate. You can also make a capital loss, when you sell your investment property for less than you initially paid for it.

Let’s now look at how you can minimise the amount of tax you pay by maximising the deductions you claim.

What tax deductions can you claim on an investment property?

If you want to maximise the return on investment (ROI) of your rental property you should claim all eligible tax deductions on property-related expenses. This is an effective strategy if your property is negatively geared, where you can deduct the full amount of rental expenses against your rental and other income.

Your property must have been rented or available for rent to qualify for any deductions. You also need to ensure you keep all receipts and invoices relating to the expenditure of your income-generating rental property, so you can prove this to the ATO. Depending on the expense you can claim:

• An immediate deduction in the income year you incur the expense
• A deduction - for depreciation of an asset - over a number of income years
  

Some of the more common expenses or deductions you can claim in the tax year the expense was incurred include:

• Interest on your investment home loan. 
• Maintenance and repair costs to your rental property.
• Rental advertising costs to secure tenants, such as placing an online listing.
• Property management fees. 
• Insurance (home, contents, income protection and landlord).
• Strata fees if in an apartment complex.
• Land tax and council rates.
• Legal and accounting costs.
  

You can also claim a deduction over a number of income years for the decline in value of an asset over time. Otherwise known as depreciation, this applies to items like appliances in your rental property which age over time. You can either use the: 

• Prime cost method, which is an equal tax deduction each year over the item’s life;
  or
• Diminishing value method, which uses higher claims in the early years of the item’s life, which get progressively smaller over time.
  

The rules around depreciation are complex so most investors get professional advice, including the services of a quantity surveyor. They have the expertise to estimate the declining value of a building and its fixtures and fittings using a depreciation schedule. Depreciation rates range from 2.5% to 4% of the value of a building or an asset.

There are also expenses for which you cannot claim deductions for, including:

• Costs associated with the purchase or sale of the property.
• Expenses incurred by your tenant, such as utility payments.
• Expenses incurred when the property was occupied by you.
  

Now let’s look at an example of a claim on a tax return for an individual who owns an investment property.

Investment property tax return example

In this example we can see how claiming deductions can help lower your taxable income and reduce the amount of personal tax you pay in a financial year.

Assuming an individual with an annual income of $121,000 with a $500,000 investment home loan, paying interest only at an interest rate of 2.66%, with the following claimable expenses:  

The rental property also generates a rental income of $375 per week which is $19,500 per year.

The basic formula for calculating taxable income after deductions would be:

Total Income (salary+rent) - Total Deductions (interest, management expenses)

$121,000 + $19,500 - $21,850 = $118,650.

Tip: The ATO has excellent resources explaining how to treat rental income and expenses, with detailed guidance on what you can and cannot claim. Property investors should also seek professional advice - from a tax accountant or financial advisor - so they are compliant with the law and claim the right deductions. Tax legislation is constantly changing, so a tax professional will know what applies when you submit your tax return.

Have any questions about tax and investment property - or anything else? We’re happy to help, and our local team are available to chat at a time that suits your schedule.