Claiming Interest During Construction: Richard & Zarina’s Land
Overview- Richard and Zarina, esteemed professionals in their fields and seasoned property investors, hold a portfolio that reflects their confidence in real estate ventures. Following a consultation with their mortgage broker, they learned that their borrowing capacity is capped at $800K, supplemented by $300K in savings. The pair has set their sights on North-Western Sydney, a growing hub for young professionals aspiring to construct new homes, where vacant plots are swiftly changing hands.
Their thorough research reveals that properties in this locale typically appreciate, yielding profits upwards of $50K annually. Encouraged by these insights, Richard and Zarina are determined to acquire a plot valued at $600K, with the intention to build a rental property. The initial investment entails a $30K withdrawal from their equity loan, which will incur interest charges.
Ten months after the initial contract signing, during the tax season, they approached us for a consultation. With the land registration only three months away, they sought to understand the tax implications of their strategic investment, particularly if they decide to sell the land due to concerns about rising construction costs. Additionally, they are seeking our advice on the tax deductibility of their holding costs.
Cost of Holding Vacant Land
The costs involved in holding vacant land while waiting for registration include:
- ongoing borrowing costs, including interest payments on money borrowed for the acquisition of land.
- land taxes will be charged after registration as they have crossed NSW Land tax Threshold.
- council rates
- maintenance costs.
Our Advice – There have been changes to legislation aimed at limiting deductions for expenses incurred while holding vacant land, effective from July 1, 2019. This legislative change will affect vacant land held before July 2019. The majority of clients are unaware of these changes to deductions for vacant land. We have structured our advice in two sections –
Deduction – Expenses or outgoings associated with holding vacant land are not tax-deductible unless the land is being utilised or is available for use in conducting a business.
Some of these holding costs are:
- loan interest.
- council rates.
- land tax.
Vacant land, as mentioned in section 26-102, refers to land without any significant, permanent buildings that are being used or could be used independently, not just as part of another building’s purpose. If a property is under construction or major renovation, it’s not considered a significant, permanent structure until it’s legally ready to live in and is actually being rented out or is ready to be rented.
Based on the information provided, Richard and Zarina cannot claim any tax deductions in the form of negative gearing on their tax return for this vacant block of land.
Entities that are not affected by this Legislation – Certain entities and individuals under specific conditions may still be eligible to claim deductions for expenses related to holding vacant land. For instance, deductions may be applicable if the land-holding entity is a corporation, the land is actively used for business purposes, or in cases of exceptional circumstances.
Deductions for expenses incurred in holding vacant land can still be claimed if you fall into one of the following categories:
- Corporate tax entities
- Superannuation plans (excluding Self-Managed Superannuation Funds known as SMSF)
- Managed investment trusts
- Public unit trusts
- Unit trusts or partnerships provided all members are entities from the categories listed above.
Sale of Vacant Land – Under current Capital Gains Tax (CGT) legislation, holding costs that cannot be deducted can be added to the asset’s cost base. This inclusion effectively reduces the capital gain realised when a CGT event takes place. Essentially, this means that while certain expenses might not provide immediate tax relief through deductions, they can still play a crucial role in decreasing the taxable gain when the asset is sold or undergoes a similar CGT event.
The types of expenses that can be incorporated into the cost base typically include those costs that are normally associated with the asset’s acquisition and maintenance. Examples of these expenses are interest charges on loans used to purchase the asset, local council rates, and any stamp duty or comparable duties paid in relation to the asset. By including these expenses in the cost base, the overall capital gain on the asset when it is eventually sold can be effectively reduced, potentially leading to significant tax savings.
For example – Richard and Zarina purchased the land for $600,000. Including stamp duty and legal fees, their total acquisition costs amounted to $25,000. Over time, they incurred $20,000 in interest expenses and $600 for various rates, while they did not have to pay any land tax, as their land’s value in New South Wales fell below the land tax threshold. Their initial plan was to develop this vacant land into a rental property. However, should they fail to proceed with this development, they might face capital gains tax upon selling the land. Assuming the land is later sold for $800,000, with $15,000 in sales-related expenses, the capital gain they would realize is calculated as follows:
Sale price of the land: $800,000
Minus the original purchase price: $600,000
Minus acquisition costs: $25,000
Minus interest expenses: $20,000
Minus rates and other expenses: $600
Minus cost of sale: $15,000
This results in a capital gain of $139,400 from the sale of their land. We have shown them our capital gain calculator to identify their capital gain tax consequences.
Conclusion – In navigating the complex landscape of property investment, Richard and Zarina’s journey underscores the pivotal role of informed decision-making and strategic tax planning. Their case highlights the complexities inherent in managing investments and the tax implications that accompany them. The evolving nature of tax laws and investment opportunities demands caution and adaptability.
Are you contemplating a property investment or grappling with the tax implications of your current investment portfolio? At Investax Group, we specialise in providing tailored property tax advice that aligns with your unique investment goals and circumstances. Whether you’re a seasoned property investor like Richard and Zarina or just beginning your investment journey, our team is here to guide you through the complexities of property investment and tax planning.
Pro tips
Capital Gain Tax – The Australian Taxation Office (ATO) may scrutinise the capital gains tax on vacant land if owners cannot demonstrate a genuine intention to purchase and build a rental property. One indicator of genuine intent could involve consulting various builders to obtain draft designs and construction estimates for the vacant land. If the primary intention appears to be purchasing and then selling the land for a profit, the ATO might view this as a profit-making venture and could disallow the 50% capital gains tax discount.
Claiming Deductions – You may still be eligible to claim deductions for holding costs even if your situation differs from that of Richard and Zarina. For the expenses associated with holding land to be deductible, they must have been incurred in the course of conducting a business, such as farming, or in earning or producing assessable income.
Plan for Exit Strategies – Always have a clear exit strategy for your investment. Understanding the tax implications of selling your property can help you make informed decisions when the time comes.
Optimizing Ownership Structures for Tax Advantages – When considering the acquisition of vacant land as part of your investment portfolio, it’s crucial to understand how the ownership structure can impact your ability to claim deductions for holding costs. Implementing a strategic ownership structure can be a savvy way to navigate these tax implications. For Instance, If the land is held by a corporate tax entity, you may still be eligible to claim deductions for holding costs.
Seek Expert Guidance: Navigating the intricate world of property taxation can be daunting. To ensure your investment journey is both compliant and optimised for tax efficiency, enlisting the services of experienced property tax specialists is key. If you’re in need of expert guidance through this complex terrain, don’t hesitate to reach out to the team at Investax Accountants. Our seasoned professionals are well-equipped to provide you with personalised advice that caters to your unique investment scenario, empowering you to make informed decisions with confidence.
Reference
https://www.austlii.edu.au/cgi-bin/viewdoc/au/legis/cth/consol_act/itaa1997240/s26.102.html
https://www.revenue.nsw.gov.au/taxes-duties-levies-royalties/land-tax#heading1
https://investax.com.au/calculator/capital-gain-tax-calculator/