08 March 2012

Pre paying interest on your rental property

Paying your interest in advance can have more than one benefit for investment loans. The ability to pre-pay interest is appealing to property investors, rather than owner-occupiers, because only investors are able to claim a tax deduction for interest payments on their loan as well as other costs.

By paying 12 months interest in advance, investors can claim the deduction this financial year, rather than wait 12 months for the tax benefit.

The strategy is especially appealing whenever tax cuts are scheduled for an upcoming financial year. It makes sense to bring forward deductions to a year when you are liable to pay more tax. So, whenever tax cuts are scheduled to be introduced on 1 July, make sure that you consider prepaying interest in June for the upcoming financial year.

You should also consider prepaying interest in one financial year if you expect to receive less income in the following financial year.

But the ability to pre-pay interest is only suited to individuals with the cash flow to take advantage of the opportunity, not just this year, but each year for the term of the loan.

Twelve months' interest on a $250,000 loan would amount to $17,850. This is a significant amount of cash to have on hand and while the full amount is tax deductible, the amount you get back is determined by your marginal rate. Hence, someone on the top rate of 46.5 per cent who paid $17,850 interest in advance and claimed it as a tax deduction would get back $8300 through the tax system but still pay out $9550.

Investors need to ask themselves if the strategy will be ongoing and for how long. If you think rates are likely to go up in the next 12 months and you know you will have the ability to pre-pay interest on an annual basis for a number of years, it may pay to fix your rate for longer.

Borrowers can make arrangements with the lender to have the loan drawn down in time to allow pre-payment of interest by June 30.

What expenses you can claim

If you own an investment property, you may be able to claim a tax deduction for a raft of expenses in addition to the interest on your loan.

The Australian Taxation Office advises on its website that you can claim expenses relating to your rental property but only for the period your property was rented or available for rent - for example, advertised for rent. A very handy ATO guide is Rental Properties Guide

When landlords claim body corporate fees, they should also make sure they don't include contributions to sinking funds, which can't be claimed as a deduction. Items such as fridges and washing machines can't be claimed as an upfront deduction but must be depreciated over a number of years. Depreciation can be claimed for items such as freestanding furniture, whitegoods and TV. You can claim the full amount of items costing $300 or less in year one.

You may also be able to claim a capital works deduction for construction costs such as improvements to driveways, fences and retaining walls.

Expenses could include:

  • advertising for tenants
  • bank charges
  • body corporate fees
  • borrowing expenses
  • council rates
  • decline in value of depreciating assets
  • gardening and lawn mowing
  • insurance
  • land tax
  • pest control
  • property agent fees or commissions
  • repairs and maintenance
  • stationery
  • telephone
  • water charges, and
  • travel undertaken to inspect the property or to collect the rent.

Additionally, if part of your property is used to earn rent, you can claim expenses relating to that part only. You will need to work out a reasonable basis to apportion the claim. For example:

If a two storey private property leased the second floor, representing 30% of the total floor area, and allowed use of the laundry (an area that takes up 10% of the total floor area of the house), the owner can claim 35% of the expenses for the property; this equates to 30% (second story), and 1/2 of 10% (laundry) = 35%.

Taxation Ruling IT 2167 - Rental properties will give you more details about apportionment. [source: www.ato.gov.au]

Best regards

Iain Pepper


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