The marginal rate of tax or MRT
is the percentage of tax
levied on the last dollar earned.
It doesn’t mean that you pay that percentage overall, just on the number of dollars that are in your highest tax bracket.
Tax rates applicable in 2020-2021 (excluding the Medicare Levy of 2%) are:
Someone on $125,000 is in the 37% marginal rate but they would probably pay approximately 25% of their income in tax because some of their income incurs ZERO tax and some 19% and some 32.5% and some 37%
In this example, assuming no deductions, the tax-payer is liable for approximately 25% of their income in tax even though they fall into the 37% tax bracket – $31,317 / $125,000 = 25%
The Medicare Levy is then applied to your taxable income. If taxable income is $125,000, then 2% or $2500 would be added to this taxpayer’s liability. $31,317 + $2500 = $33,817 which = 27% of their total income. ($33,817/ $125,000)
If you can reduce your taxable income with legitimate costs incurred in earning an income (including property-related), the tax payable will be calculated on the lower level of income and not your total earnings. You will have the opportunity to reduce your tax payable on income and the Medicare Levy payable as well.
Using the example in the negative gearing topic, assume this taxpayer has an investment property earning $25,000 per annum in rent and costs of $33,500 plus depreciation benefits of $10K (it’s a brand new property). This means the new gross income becomes $150,000 ($125,000 + $25,000). The allowable deductions are $43,500 ($33,500 + $10,000). The new taxable income becomes $106,500 ($150,000-$43,500). Tax payable will now be calcuated on $106,500, not on $125,000.
Total tax liability now equals $25,079 + $2130 = $27,209 or 18%
This taxpayer’s liability has been reduced by $6,608 (or $127 per week)
Australia has a progressive system of income tax. The more you earn, the larger proportion of your income is paid in tax.
The GST, for example; is a flat rate of tax for all, and therefore more of a burden on low-income earners than it is for higher-income earners.
It is a regressive tax.
Tax brackets are adjusted to achieve a more equitable tax system.
‘Bracket creep’ occurs when incomes rise as a result of inflation, and tax-payers are forced into higher marginal tax brackets. They can’t buy more with the ‘extra’ income because it is a result of inflation (a general increase in prices) and so they are negatively impacted.
Tax liability is assessed on ‘taxable income’ = gross income minus any allowable deductions.
Rental income from an investment property is considered income and as such is added to your gross income.
BUT all the costs of ownership can be deducted from your gross income as can depreciation.
The rate at which you can claim tax credits from the ATO is at your highest marginal rate of tax.
Tax minimization through negatively geared property investment is legal, and an Australian Tax Office supported tax strategy.
It is a requirement to keep accurate records of all expenses.
A Quantity Surveyor’s Report (QSR) professionally prepared for every investment property is essential to ensure that the maximum depreciation benefits are claimed.
Three recommended purchase costs.
- Quantity Surveyor’s Report
- Independent Building Inspection
1. Property depreciation relates to the fact that over time the property and its contents wear out. A QSR or depreciation report is imperative for the property investor. Prepared by a professional, qualified, Quantity Surveyor, the report presents estimates of the costs entailed in building a property.
A depreciation reportis a one-off cost for the life of the property.
The Australian Tax Office provides generous benefits in terms of non-cash deductions to property investors. Non-cash refers to the fact that the investor does not need to have spent the money to claim depreciation; it is simply an allowance made by the tax office.
Capital works (the cost of the building itself) can be claimed at 2.5% per annum for 40 years. (40 x 2.5% =100%)
If the property is new, the investor can claim the deduction for the next 40 years or if a resale property, for the remaining term up to 40 years.
The value of Plant & Equipment (fixtures and fittings) includes things like carpets and tiles, dishwashers and airconditioning units etc. The ATO defines and sets the ‘effective life’ of these inclusions in a home. The investor usually is permitted to claim a percentage of their value over a 5 to 10 year period.
Since recent changes to legislation,
the deductions for fixtures and fittings is now only
permitted for new property
The exception is a window of 6 months for a developer who tenants a property before its sale.
Depreciation is a significant and valuable claim that can make a big difference to the bottom line holding costs for a property investor.
Engaging a professional to prepare a QSR is a cost-effective and rewarding exercise that many investors neglect, costing them thousands in lost claims.
Courtesy of BMT the following figures illustrate the beneficial effect on holding costs of claiming the maximum non-cash benefit possible. Professional preparation of a depreciation report (Quantity Surveyor’s Report) is essential.
2. An independent building inspection is optional but recommended. For new property, builders have their own quality control procedures to ensure that the construction, fit-out and finishing, comply with their standards. A three month warranty period is the standard during which any defects can be identified, itemized and reported to the builder for rectification.
However, it’s advisable not to take the builder’s word that all is fine and have an independent, licensed builder inspect the property to pick up on any issues ahead of time and allow the builder the maximum time to rectify these before the handover of the property.
ASPIRE engages Handovers.com on our client’s behalf to complete a thorough examination of the properties.
They then liaise with the builder to have the identified issues attended to and ask the builder to confirm that they have done what they needed to do. Once they have, the inspector goes back to verify, and if any items remain outstanding, the report forms the basis of the three months standard warranty period.
A small sample of what an inspector will inspect:
These are items that even the most thorough investor is likely to miss or not even consider!
The tax-deductible fee for a professional report is again, money well spent.
3. Any investment carries some risk. The contingencies associated with property investment relate to loss associated with the physical asset and the rental income it is contracted to deliver.
Insurances are a fundamental risk mitigation approach.
Building insurance will indemnify the owner against loss or damage to the house, garden shed, fences and other structures on your property. The damage may be a result of ‘acts of god’ or natural disasters, or fire, burst pipes etc. and also it will include cover for legal liability if someone else is hurt while on your property.
Flood cover is specially treated. The insurer will distinguish between stormwater damage and rising floodwaters. Protection for flood damage may be denied if the property is in a designated flood zone or the premiums may reflect the degree of risk.
(Flood zoning is an important check to make before purchasing a property. )
If the property you are buying is part of a strata scheme (townhouses, apartments, etc.) the body corporate will insure the premises as a whole, and the building is protected under the umbrella policy. The only insurance you would then need to arrange would be Landlord Insurance and Contents.
Landlord insurance protects against malicious damage by tenants and the loss of rent through default of payment.
The contents you insure would only be the fixtures in the home, not the possessions of the tenant, that is their responsibility.
What’s the bottom line?
A very important step in choosing an investment property is to have the cash flow figures worked for you to make sure that the property suits your financial circumstances.
There are several professional programmes designed for this purpose, but with any computer-generated information, the output is only as good as the input.
A qualified and professional Property Advisor will provide the assumptions their model is based on and explain why these are important.
Based on these assumptions after rent and tax rebates and all associated costs, the property should return approximately + $35 per week to the investor.
This result assumes that the tax rebate of $4,420 is collected week by week after submitting a PAYG Withholding Variation. If it weren’t, then the investor would need to contribute approximately $50 per week.
Calculated by taking away the expenses ( interest cost and the rental expenses) from the income the property generates (rent) : $21,403 – $16,195 – $7,818 = – $2,610 / 52 = $50.19 per week:
Manipulating inputs such as anticipated rent, vacancy rates, inflation rates etc. will distort the truth and impact the bottom line result, making the costs appear better than they are or implying growth in capital value and rental income that cannot be guaranteed.
Be wary of rental guarantees – these sometimes provide a subsidised rent from the developer or the vendor at higher than market rates for a limited time. These can be very worthwhile and a great way to start with rental income right from the point of settlement, BUT if the cashflow is worked based on this ‘inflated’ rent, it will not give an accurate long term view of the holding costs. Sometimes they are used, and after the guaranteed period ends, the property owner receives a shock when suddenly they are asked to contribute more to the property than was projected at the point of purchase. Always ask your advisor to work the figures at verified market rates to see if you are still comfortable with the bottom line.
However, if the vendor is offering a rental guarantee that corresponds to current verified market rates or has identical properties in another development already achieving that rent, then the guarantee is a legitimate bonus.
A powerful way of looking at the affordability of a property investment purchase is to see who will pay to cover the holding costs of the property.
In this particular case, after rent and importantly, PAYG tax credits are collected, the property costs, on average, are serviced by both the tenant and the ATO:
Gearing is borrowing
to buy an asset
with a small personal contribution and
borrowing the rest from others
Property investors aim to earn income from the property in the form of rent in the short term and a capital gain, long term.
Property investment is negatively geared when the rental income doesn’t cover all the costs associated with owning the property.
The Australian Tax Office allows property investors to reduce their taxable income by the amount of the shortfall.
It is also important to note that property can be positively geared, where the income received exceeds the holding costs. Neutrally geared property exists where after all income and expenses are calculated, the property ‘breaks even’, that is the rent covers the expenses but no more.
Any property can be positively or neutrally geared depending on the LVR and the size of the investor’s contribution.
Typically though the idea of a positively geared property relates to the concept of the rent exceeding the holding costs with only a minimum deposit, this is more likely in rural areas where prices are low and rents typically much higher relative to the purchase price. The trade-off may be lower capital growth long term.
Why negative gearing is here to stay
= “Why negative gearing is here to stay…”] Once again the idea of changing the tax benefits afforded to investors via negative gearing has been floated in the context of broader tax reform.
Australia is a market economy and, in a perfect world, freely operating markets are efficient and deliver maximum satisfaction for all. But it isn’t an ideal world. Sometimes market solutions are inadequate, inequitable and lacking in social responsibility- you only have to look at the causes of the GFC to see a classic example!!
There is a role for government to redistribute income and resources in ways that enhance market solutions and compensate for market failure.
Tax benefits for negatively geared investment property are a perfect example of government policy designed to achieve a desirable market outcome. The government provides tax incentives for individuals to invest in property, especially new property, thereby increasing the stock of available housing and delivering significant employment opportunities as a byproduct. The stimulus to private sector property investment through tax concessions helps to redress the housing imbalance and reduces pressure in the rental market.
It also importantly promotes entrepreneurial spirit, the building block of the market system, and is an incentive for individuals to create wealth for their retirements, thereby reducing the burden on future generations. Shifting the goalposts to be eligible for the age pension to 67 after 2023 is in direct response to the looming crisis in the economy’s ability to support an aging population that no longer contributes to the public purse.
We all need to become proactive now so that we don’t end up reliant on the overstretched welfare system in the future. It is also essential to understand why tax benefits are maximized on a new property through depreciation.
Depreciation means that you are allowed to claim a proportion of your property’s value, the building and its fixtures and fittings, for wear and tear over time as another cost of ownership. This claim is most substantial in the early years of a property’s life and so building a new property is the best way to take advantage of the ATO’s concessions.
A healthy building industry is vital for economic growth and employment. The multiplier effect of construction means not only work for tradespeople and suppliers, but it has a ripple effect on the retail industry for white goods, carpets, blinds, turf, fencers, landscapers, moving companies, and the list goes on! No wonder the government considers ‘housing starts’ a leading economic indicator.
Policy changes involve trade-offs and disincentive effects, both intended and unintended. Removing tax advantages for property investment would reduce the supply of housing and put the onus back on the public sector to provide more public housing.
Housing construction is an important injection into the circular flow of income in the Australian economy – it is an essential driver of employment.
Construction contributes approximately 8% of GDP and employs more than 1 million people.
Indirectly, many more workers are employed to provide the complementary goods and services that housing (both residential and commercial) necessitates.
To stimulate housing starts and the economy through the multiplier effect of construction, the government provides generous INCENTIVES and CONCESSIONS for those investing in a brand new property.
A depreciating asset is one that has a limited effective life and can reasonably be expected to decline in value over time.
Property investors can claim depreciation as a non- cash deduction as a cost of owning the property and renting it to a tenant. Non- cash refers to the fact that the money doesn’t have to be paid out by the owner first, it is merely an allowance made by the Australian Tax Office for investors to reduce their taxable income.
There are two categories of depreciation allowances available to the property investor:
CAPITAL WORKS – (the constructed building) can be claimed as ‘losing value’ (even though market value increases) at a rate of 2.5% pa for 40 years. (2.5% x 40 years =100%) This concession applies to both new and resale property (under 40 years old)
FIXTURES & FITTINGS –
You can claim for new assets; not second-hand or previously used.
This allowance includes where you purchase a newly built or substantially renovated property, for which no one was previously entitled to a deduction for the decline in value of the depreciating assets, and either:
No one resided at the property before you acquired it, or the depreciating assets were installed for use, or used at this property, and you acquired the property within six months of it being newly built or substantially renovated. Following ATO guidelines on the ‘effective life’ of the asset, your accountant will typically claim depreciation of the fixtures and fittings in a new property such as carpets, window blinds, oven and hot water system etc. over 5-10 years.
This is a significant deduction and since 1 July 2017
is only available on new properties
or substantially renovated ones
This policy change is an example of a targeted change to the tax system to influence the allocation of resources and to encourage investment in new properties given the employment and welfare effects of new construction.
Think of how significant and beneficial new housing starts will be to the recovery of the economy post-COVID-19. The government will be encouraging new builds, which via the multiplier effect will contribute significantly to production, employment and incomes in the construction industry and the retail sectors.
Update as of 4 June: “The Federal Government will give eligible Australians $25,000 to build or substantially renovate their homes, in an effort to boost demand in the construction sector and keep builders employed.” ABC News
Brand new properties are often part of master-planned estates with attention to open space and attractive streetscapes. Consistency of housing and covenants (building and design guidelines applicable to a new estate) means that it is unlikely you will end up next to an ‘eyesore’!
New property normally requires minimal maintenance with no renovation expenses. The building carries mandatory warranty periods as do the new appliances installed in the property.
A new property is appealing to tenants.
New properties are built with changing demographics and trends in mind, enhancing the market appeal for tenants and on resale. For example, the trend towards open-plan living is making outdated the formal living areas that don’t match changing lifestyles and preferences. Changing family compositions can be deliberately catered for in new designs. Duplex and dual-key designs are catering to the growing demand for accommodating elderly family members as an alternative to assisted living options.
Consider the impacts on the workforce as a result of work from home orders. Prior to the pandemic, only 5% of workers were in home offices. During COVID-19 it increased to 45% and the new normal is expected to settle at around 15%. This is an example of a structural change to the way we work. The suburbanisation of work will have flow-on effects for the demand for housing in middle to outer ring suburbs and well resourced regional areas. It will also influence the design of housing.
The home office space will be a priority for many. New builds afford the opportunity to meet the changing demands of work expectations and arrangements. Then consider the rise in homeschooling and the need for separation and quiet. Some new multi-dwelling constructions are providing dedicated, communal workspaces for residents to access away from interruptions and the demands of family or other cohabitors.
If the property is a house and land contract to be built, stamp duty is only paid on the value of the land and not on the contract price. This offers the investor a considerable saving. There is, however, interest to be paid on the loan during construction. This, combined with the stamp duty on the land, can equate to stamp duty on a completed package. Both of these costs can be offset against any capital gains tax liability when the property is eventually sold.