For most investors, tax is simply an unpleasant but necessary part of the effort of building and growing wealth. While investors would like to keep all of their investment income, they also accept that they must reluctantly part with some of their earnings every year.
If you're an Australian property investor, however, it's a little different: Tax can be your ally when it comes to growing your wealth. Provided you target the right type of property and claim the most important deductions, you can end up having your property investment funded by your tax bill along with the rent. All it takes is following a basic step-by-step process.
Minimise stamp duty
Every purchase of property in Australia comes with the payment of stamp duty on top. One way of minimising stamp duty is purchasing new house and land packages with separate contracts for the land and the house. This way stamp duty is only paid on the land component.
At times state governments provide stamp duty incentives. For example, the state government of Victoria provides reduced stamp duty on new 'off-the-plan' apartment purchases. Similarly, the New South Wales government currently offers a stamp duty concession that, with the right piece of land, you can take advantage of to limit the capital cost of your investment.
Unlike other states, which require buyers to be first-time purchasers in order to capitalise on the rebate, both owner occupiers and investors can make use of it in NSW. Buyers will see $5,000 taken off their duty on either a new home, an off-the-plan property or land on which a new home will be constructed. The property simply has to be valued at under $650,000, while the vacant land must be worth less than $450,000. You can make use of this rebate for multiple investment properties, as long as you limit yourself to one per financial year, per person.
Along with this concession, it's important to remember that buying or building a new home comes with other tax advantages, namely a higher rate of depreciation. In fact, this should be another major part of your tax strategy, particularly if you are going to buy or build a portfolio of properties. The cash flow from tax-effective properties will help you maintain financial momentum to allow you to keep building your portfolio.
Case study: Established property vs house and land packages
To demonstrate how beneficial these stamp duty savings can be, let's say you have an old terrace in Paddington, NSW, worth $2 million. For a property of this value in NSW, you would pay stamp duty of $95,490.
Now compare this to three house and land packages that add up to the same value of $2 million, around $666,000. Assuming the land value is $300,000 in each property, the stamp duty will be $11,000 each, totalling $33,000. This saves you over $60,000 in upfront stamp duty taxes. Whilst you have to pay the holding interest during construction, this amount is tax deductible in the financial year you pay it. All in all, with the current low interest rates, this will work out to be less than paying the total amount of stamp duty upfront, on a completed property.
Make use of depreciation
Depreciation allows you to use the natural decline in value of the construction materials and equipment to lower your overall tax bill. Experienced property investors are well aware of the benefits that can come from this. In 2012-13, there were 857,975 capital works - or building cost - deductions, which were ultimately worth a total of $2.4 billion.
In order to claim the deductions, you'll need to have a quantity surveyor come and inspect your property and draw up what's known as a depreciation schedule. Fortunately, quantity surveyor fees are completely tax deductible, allowing you to even further bring down your tax bill.
Let's say each of these new home builds cost $366,000 ($340,000 for the building and $26,000 for the fixtures and fittings). This would provide you a combined depreciable value of about $1,098,000 in your $2 million property portfolio, which will substantially lower your tax bill.
You can claim 2.5 per cent of the building cost on these new homes, as depreciation allowance, giving you tax deduction each year of $25,500 for 40 years, which works out to the total original cost of investing in this property in the first place.
On top of that, you will be able to claim a tax deduction for the cost of the fixtures and fittings over the course of the first seven years. Assuming you claim a depreciation allowance of 15 per cent on these items, that will give you an additional $11,700 (approx.) of tax deductions each year for this period.
The combined annual tax deductions for the building, fixtures & fittings will be $37,200. The tax refund on the middle tax bracket of 38.5 per cent would be $14,322. That's an extra $275 per week. Over 40 years the depreciation tax benefit on this tax bracket is over $400,000, about $10,000 a year.
Compared to the old terrace, that's a lot of cash-flow to forsake.
Diversify across different states to minimise land tax
Yes, there's another tax: Land tax. In addition to personal income tax, capital gains tax (paid on a gain you've made on the sale of a property) and stamp duty on purchase, you can also be exposed to land tax if you exceed the land tax threshold for the state you hold property in. Because land tax is state-based with varying tax thresholds, some states can be more advantageous than others. Also, by holding property across different states and in the names of different people or a trust, you can minimize the land tax exposure within your property portfolio.
Returning to our example of buying a $2 million terrace in Paddington, the land value would be the primary component of the price - around $1.7 million. Because of the age of the property, the building value would be a lot less. The land tax exposure within NSW would be 1.6 per cent for every dollar above the current threshold of $432,000. If we subtract this amount from $1.7 million and work out 1.6 per cent of the result, this would be equal to $20,288 per year, every year. As the land value increases, so would the land tax cost. The thresholds may be increased each year, but often not as much as the land values. Over 20 years this would equate to an at least an additional $500,000 in cash out of your pocket.
Coupling the tax depreciation benefit of three new house and land packages, that are well placed to minimise land tax, compared to the old terrace in Paddington would equate to approximately $30,000 a year difference for the newer properties. You are also most likely to get a higher rental yield on the new properties with less maintenance costs.
Most people don't do the math or understand the various tax strategies they can employ on a well-structured investment property portfolio. In this example, the difference would be about $600 a week. This certainly positions a wise investor to continually build financial momentum for future property acquisitions or debt reduction to increase their wealth.
Often the primary reason of investing in property is to create a passive income. Buying properties that will drain your cash-flow defeats the purpose.
Is cash king? Case study: Property investment vs term deposit
To see just how beneficial taking this approach to your property portfolio could be, it's worth comparing a properly depreciated real estate investment to a more typical vehicle Australians might use to invest. According to Roy Morgan Research, as of June 11 2014, 1.97 million Australians held term deposit accounts. Term deposits are considered good investments by some because they are a relatively risk-free way to get returns. But how do they stack up against an investment property?
Let's say you have $1 million to invest in either a property or a term deposit. Having a cash flow positive property worth $1 million might provide you with a 5 per cent rental yield each year, or $50,000 of rent. Minus the expenses needed to run the property - say $10,000 - this would leave you with a net rental income of $40,000. Assuming you claimed depreciation of $15,000 a year, that meant you would only pay tax on $25,000 of that income, hence leaving you with $15,000 of tax-free earnings.
Now let's imagine that instead of purchasing a million dollar property, you put that same amount of money into a term deposit offering a 4 per cent rate on maturity. This would also produce a profit of $40,000 - however, unlike with an investment property, you would have no way to reduce your tax bill, leaving you having to pay the full tax on the profit. Over time, this would add up significantly.
This does not include the potential increase in the value of the property either. If you had a conservative capital growth rate of 4.75 per cent per annum, your $1 million property would be worth more than $2 million in 15 years. That's at least another $66,000 each year in growth, safe from income tax.
Taking advantage of what's there
At the end of the day, it's all about making use of what already exists to bring down your tax. Tax benefits like depreciation are there to help you realise your investment goals, and with a capital intensive form of investment like property, it makes sense to use what you can to lower your up-front costs. If you minimise your tax bill over your entire portfolio over the course of years, you'll be surprised how much you'll save - and how far you'll go.