This is a brief overview of things to consider before purchasing a rental property as an investment. For further property investment advice, click here.
Before you invest in property
Deciding how to own an investment property has important tax consequences, so it pays to get it right from the start. The first step is to make sure that when you sign a Sale & Purchase agreement for a new property, that you have the option of deciding later what entity will own the property. If you simply put your own name on the Sale & Purchase Agreement then it has to be owned by you personally.
This is not always an ideal situation. Especially, if you subsequently decide you want to put it into a trust or company, as this will result in additional legal fees to change the ownership. A way around this potential problem is to always make the purchaser your name “… and or nominee” on the Sale & Purchase Agreement. This gives you the option to nominate the entity which will own the property at a later date. You can even go unconditional on the purchase of the property and decide on the entity before settlement. Thus allowing you time to check with your accountant.
Furthermore, you also have time to set up your trust or company, depending on which structure is best for you.
Property Ownership Structure
There are three main ownership options.
- Your own personal name or names,
- a Company, or
- a Trust.
If asset protection is your main objective then a trust may be the best structure. But keep in mind that losses cannot be distributed from a trust to beneficiaries. If your primary source of income is from wages or salary you probably wouldn’t want to own an investment property in a trust as it is unlikely you will be able to off set the losses against your income and thereby obtain a tax refund.
Until tax changes in 2011, a special company called an LAQC was probably the best option for owning your investment properties if your main source of income is from salary or wages. This would allow you to easily access losses, and thereby obtain a tax refund. However, you will not have asset protection, as the shares of the company will be in your name. Now, you will need to decide between a Qualifying Company or a Look Through Company if you wish to hold property in a company.
Which Costs are Deductible?
Perhaps the easiest way to answer this is to talk about what isn’t deductible. Here’s a list of items that are not deductible
Principal repayments on the mortgage. It is only the interest that is deductible
- Real estate agent’s fees on purchase and sale of the property
- Capital expenditure. These are items which add value to the property or are new assets on a property. For example a new deck adds value to the property and therefore that cost cannot be deducted. However repairing a deck is a deductible expense. If you are not sure about an item, it always pays to check with an accountant. This area of expenditure can be grey and sometimes it can be hard to distinguish between a repair and an upgrade.
- The IRD does not consider the legal fees relating to conveyancing tasks (putting the property in your name) to be deductible. However legal fees relating to registering a mortgage against a “property are considered to be tax deductible. For this reason ask your solicitor to split the invoice between these items.
- Travel costs relating to sourcing a property are not deductible. However travels costs in relation to earning renta l income, eg conducting regular inspections, are deductible.
Good and Bad debt
When arranging financing the documentation must record the property owner as the borrower and that the funds are applied to the purchase of the investment property. How the owner secures the loan is irrelevant to the deductibility. A common mistake that many make is to borrow money to purchase a second house that they then live in, while renting out their first house – which often has little or no mortgage.
Once again this is not an ideal situation, as the interest on the funds borrowed will not be deductible. This is because the borrowed funds were not used to purchase the rental property. However, by selling the original home to a company or trust, which has to borrow to purchase the property it is possible to avoid this situation. As now the new company or trust can rightly claim the interest on its borrowings with 100% deductibility.
First of all it is mandatory for you to deduct depreciation. .In fact, if you don’t claim depreciation in your income tax return(s), for whatever reasons, you may still have to recover depreciation when you dispose of the asset. However, there are a few assets which do not depreciate, one of which is land.
Your investment property is basically made up of three components:
- Land Value – no depreciation deduction
- Building Value – Depreciation at 3% is no longer available for residential investment property
- Chattel Value – Depreciated between 10% to 60%
To maximise the depreciation claim where the cost is not separately stated in the Purchase and Sale Agreement it is advisable to obtain a chattel valuation. The benefit of obtaining a chattel valuation can be significant – often saving you $1,000’s in tax per year.
Furthermore, if and when you sell the property, quite often (unlike the Building Value) the value of the Chattels have decreased over time – thus you also minimise your depreciation recovered at the time of sale.