Investment in residential property has become something of a rite of passage for many Australians. The security of bricks and mortar and the prospect of attractive capital gains has led many to embrace this form of investment as a pathway to wealth creation.
One of the most appealing features of this form of investment is the ability under Australian tax law to offset losses on the property, often brought about by negative gearing, against income from other sources.
Every year investors in residential property eagerly tally up the cost of their outgoings to see just how much tax they’re going to ‘save’.
Tax agents and the ATO scrutinise countless tax returns each year to ensure that rental income is fully declared, and that expenses are appropriately claimed as deductions.
One of the decisions facing taxpayers, tax agents and the ATO is whether a cost should be claimed as a deduction in full in the year in which the cost is incurred, or whether instead the cost will form part of the property’s capital value or ‘cost base’ for capital gains tax (CGT) purposes.
Every State and Territory of Australia has a taxing regime whereby certain transactions attract a form of tax. Where the acquisition of residential property is concerned, the tax is typically referred to as ‘transfer duty’, ‘conveyance duty’ or simply ‘stamp duty’.
In most States and Territories of Australia, the purchase of residential property typically involves the acquisition of freehold title, where ultimate ownership is transferred to the purchaser upon sale. However, in the ACT, residential property is only made available to purchasers on a leasehold basis; that is, ultimate ownership is retained by the Crown. Upon purchase, buyers typically acquire an interest in an existing 99-year lease provided by the ACT Government. Upon expiry of the lease, the standard practice of successive ACT Governments is that a new lease is automatically granted for a token fee.
Where freehold title is acquired, stamp duty is not tax deductible. Instead, the cost is aggregated with other acquisition costs such as legal fees and the purchase price, to form the cost base of the property, for CGT purposes. When the property is sold, the cost base is deducted from the proceeds of sale to reveal the capital gain (or loss) made on the property. If the property was used exclusively as the purchaser’s home, any capital gain or loss realised has no tax consequences. Otherwise half of the capital gain is normally taxable if the property has been owned for longer than 12 months.
Where leasehold title is acquired, stamp duty may be deductible in the tax year in which the liability was incurred. The relevant provision is s 25-20 of the Income Tax Assessment Act 1997 that states:
(1) You can deduct expenditure you incur for preparing, registering or stamping:
(a) a lease of property; or
(b) an assignment or surrender of a lease of property;
if you have used or will use the property solely for the purpose of producing assessable income.
Property used partly for that purpose
(2) If you have used, or will use, the leased property only partly for that purpose, you can deduct the expenditure to the extent that you have used, or will use, the leased property for that purpose.
The purchaser’s use and intended use are therefore critical in determining whether expenditure on stamp duty is partly or wholly tax deductible. In the context of residential investment properties, the production of assessable income generally refers to the receipt of rent. The question of deductibility is determined by examining, when the liability for stamp duty arose, whether the property has been let and\or whether there was an intention to let the property in the future.
If for example, on acquisition, the buyer’s intention was to let the property for a year and then use the property thereafter as his or her home for a further four years before selling, then only 20 per cent (1 of 5 years) of the stamp duty cost would be deductible. While intentions may change over time, taxpayers should ensure they retain meaningful evidence in support of their intention at the time of acquisition.
While the right to claim ACT stamp duty as a deduction in full in the year of acquisition is well known to many local investors, one should not assume that the right applies automatically to all investment properties. Taxpayers who incorrectly claim deductions can be made liable for penalty and interest charges by the ATO.