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.
Purchase costs of an investment property
In addition to having the required cash deposit or available equity, the following costs are standard for a property investment purchase:
Stamp Duty – levied by each state and territory government, stamp duty is payable on the full purchase price of a one-part contract (apartments, townhouses and houses) and only on the land component for house and land, 2 part, split contracts.
Legal Fees – a solicitor or conveyancer handles the legal review of the contracts and coordination and management of the exchange and settlement process.
Loan Costs – lenders charge application/establishment fees (can be negotiated) for the loan and for stamp duty on the mortgage, their solicitor’s fees, a valuation fee, search fees and the cost of registering the mortgage.
Loan Mortgage Insurance – If the LVR is more than 80%, the lender will charge LMI. Lender’s Mortgage Insurance may be funded as part of the loan and may not require a cash outlay.
Pro-Rata adjustments– On settlement, you will have to allow for adjustments to the rates pro-rata for the year, (council rates, body corporate fees etc.,) In other words, pay your share of the annual costs.
Independent Building Inspection – it is advisable to engage the services of an independent building inspector to make sure that any defects are rectified before settlement takes place.
Quantity Surveyor’s Report – to claim the maximum deductions allowable for depreciation, it is essential to have a professionally prepared, itemized report that is handed to your accountant once for the life of the property.
Insurances – property investment like any other investment, carries some risk. Insuring your valuable asset will manage the risk via building, contents and landlord’s insurance. Lenders will require the property to be insured, naming the lender as the interested party, before advancing the borrowed funds.
As a guide, it is recommended to allow 4-5% of the purchase price for the costs of purchase in addition to the required deposit.
For example, to purchase a $500,000 property as a cash depositor, avoiding paying LMI, you would require:
DEPOSIT = $100,000
COSTS = $25,000
TOTAL = $125,000
To purchase the same property relying on the adequate available equity in other property, you would require:
DEPOSIT = NIL
COSTS = NIL
TOTAL = NO CASH OUTLAY
If the contract is a 2 part, house and land construction, stamp duty will be levied on the land component only, presenting the opportunity for a significant saving. However, there needs to be an allowance made to service the loan during the construction period.
The land is funded first, and then the house is built and paid for in stages.
One month after settlement of the land, interest will be payable on the outstanding balance.
Once construction starts, the building is paid for in stages, and so the loan balance progressively increases until fully drawn down after the final construction payment.
It’s like making ‘mini mortgage’ payments. The first full mortgage payment will be due one month after the loan is fully drawn down by the borrower.
When the reduced stamp duty applicable on land only is added up with the cost of servicing the loan during construction, it will be very similar to stamp duty payable on a single contract.
Both stamp duty and interest during construction are considered to be sunk costs and can be offset (claimed) against any capital gains tax liability when the property is eventually sold.