Negative gearing. Think positive

It's time to pay tax again and residential property investors are biting their nails. Concerned by a sharp increase in claims, the Australian Taxation Office (ATO) is targeting residential property investors in its annual audit program.

The ATO says that, in 2003-04, the number of taxpayers declaring rental income rose from 1.3 million to 1.4 million, a 7.5 per cent increase, and taxpayers declared rental income of $15.2 billion, up 12 per cent. In the same period, claims for property investment deductions increased nearly 20 per cent to $17.8 billion.

Elizabeth Goli, assistant deputy commissioner of personal tax, accepts that these blowouts are partly attributable to rent and CPI increases. We think the residential construction boom in the cities and holiday destinations, in which investors snapped up new property in a misguided attempt to minimise their tax, also has had a lot to do with it.

This year, the ATO will send letters to a 100,000 sampling of those who were new to the rental market in 2003-04 or returned to it. The letters will advise investors about common errors in claims and urge them to take care in preparing their returns.

The office will also write to 45,000 investors whose claims in 2003-04 were higher than average, reminding them to keep records to verify claims, and to check that they have not over-claimed.

Goli says: "We find that many people understate their rental income or over-claim their rental deductions. In some cases, they fail to declare all their rental income, particularly where holiday homes are concerned. Other people include principal as well as interest when claiming borrowing expenses, or claim deductions for a property that's not genuinely available for rent."

At the sharp end, the ATO expects to conduct 6000 "risk reviews" and then 3600 audits. Goli says investors who claim deductions that are disproportionate to their declared rental income are more likely to be audited.

On top of all this, the change in tax rates and brackets from 1 July this year means that higher income earners may not be able to claim as much money back.

Here's our advice about what to do if you are in one of these four categories:

The Tax Office has full discretion as to how you are penalised for unpaid tax. They may simply ask you to pay back what you owe, plus interest. The current interest rate is around 12.5 to 13 per cent p.a. They may also give you a fine, calculated as a percentage of the amount you owe. Generally speaking, fines are in the range of 10-40 per cent of the amount owed.

If you have a history of tax errors, you’re more likely to get a fine as well as having to pay back what you owe with interest. The Tax Office looks at 'intention’ '” did you deliberately try to avoid paying tax, or was it an honest mistake? They’ll also look at the nature of the error '” minor or major. Finally, remember that even if the Tax Office says you’ve made an error, you can ask for a 'judgement’ and appeal the finding.

GEARING

All this fuss about tax has some investors thinking that negatively gearing into investment property is no longer worthwhile. They could be cutting off their nose to spite their face.

Let's get back to basics. "Gearing" is borrowing '” using other people's money '” to buy an asset; "negative gearing" is borrowing to buy an asset from which is earned less rental income than is paid in loan interest and other expenses. The loss is claimed as a tax deduction against income from all sources.

Negative gearing helps investors hold onto their asset by giving back a proportion of expenses (loan interest, maintenance, rates, management etc) in the form of reduced tax liability.

KEEP THE CRACKDOWN IN PERSPECTIVE

In targeting residential property investors this year, the ATO isn't changing negative gearing provisions, or cutting down on the range of expense claims. It is simply making sure that all rental income is declared, and claims are valid.

Let's face it, 3600 audits are a pretty small sampling (0.025 per cent) of the 1.4 million taxpayers declaring rental income in 2004-05.

The only reason to be worried is if you haven't declared all your rental income, have claimed for things you shouldn't, or don't have records to substantiate your claims. If your nose is clean, you have nothing to worry about.

If anything, the crackdown is a great opportunity to decide whether you are really serious about property investment, and ready to take steps to improve your knowledge. For example, you might educate yourself about claims for rental property to better hold onto your asset without incurring the wrath of the authorities.

Even if you use an accountant, you are legally responsible for your tax return. A bit of due diligence on your part could save much hassle and stress.

THE TRUTH ABOUT TAX CUTS

Contrary to some talk, the changes to tax brackets and tax rates that took effect from 1 July will have little impact on the effectiveness of negative gearing for most taxpayers, who are on low to middle incomes.

This includes retirees who don't have a big income stream outside the age pension. Even someone earning the average full-time income of $51,000 will be in the same tax bracket as last year.

TAX RATES 2004-05

TAX RATES 2005-06

In the middle to higher income brackets, the tax changes have more impact on negative gearing benefits. If you are earning between $58,000 and $63,000, your negative gearing benefit is down from 42 to 30 cents in the dollar. If you're earning between $63,000 and $70,000, your benefits will drop from 47 to 42 cents.

Even so, the cuts won't have much effect. Think about the financial year as a whole, not just tax time. Any reduction in your negative gearing benefits will be offset to some degree by the fact that you will have less tax taken out of your wages. If you have more money in your pocket to start with, losing a proportion of your benefits at tax time doesn't make negative gearing per se a less viable way to buy investment property.

REMEMBER WHAT YOU ARE GEARING FOR

In negative gearing, the most important consideration by far '” and the one most investors fail to understand '” is the choice of asset. Negative gearing will only work effectively with a growth-focused investment (one that will grow in capital value by more than it costs you to hold the investment). For example, if holding the property is costing you $10,000 a year after tax, the property must grow in value by more than $10,000 a year for your wealth to increase.

Too many investors focus on maximising rental income and minimising tax. They negatively gear into an asset with little capital growth potential '” and then wonder why they are getting nowhere, or worse, going backwards.

Always remember that tax benefits don't make you rich. How can anyone get rich by spending a dollar and getting 47 cents back?

THE LAST WORD

If you buy assets that will grow in capital value over the longer term, negative gearing is still a valid strategy. It is not a matter of whether to gear '” it's by how much. If you are in the higher income brackets and the recent tax changes reduce your negative gearing benefits, just make sure the amount you borrow and the asset you buy align with the drop in your cashflow.

ACTION PLAN

If you're thinking of negatively gearing into investment property:

• Buy an asset that's suitable for a negative gearing strategy, one that will provide substantial capital growth. Borrowing money and incurring interest to buy an investment that provides income at the expense of growth does not make financial sense.

• Buy the asset in the appropriate name. The name in which a property is owned '” personal name, company or trust '” can have a substantial effect on your tax situation. Remember that losses sustained by a trust cannot be disbursed to the beneficiaries, so borrowing money in a trust isn't much use.
• Separate deductible debt from non-deductible debt; that is, make sure that your borrowings for investment (the property loan) are separate from borrowings for lifestyle purposes (home loan, credit card, personal loan etc). This will ensure you can claim everything you're entitled to regarding your investment-related borrowings and, thereby, keep the tax office satisfied.
• Get advice from an accountant or professional to find out what you can claim and what you cannot claim.

If you are already negatively gearing:

• Determine whether the new tax scales and rates actually affect your position. Unless you are earning between $58,000 and $70,000, there is not likely to be much impact.

• Review your cashflow situation. How much more money do you need to find, after tax, to hold this asset, and can you can afford it? If you cannot afford it, you may need to review your property investment strategy and adjust your borrowings to a more comfortable level.