Non-Deductible Expenses: Shan & Zan’s Deduction Strategy

Gratitude – I would like to extend my heartfelt thanks to Shan for his pivotal role in inspiring this case study. As a diligent reader of all our articles and case studies, Shan not only enriches his own knowledge but continually encourages our team to explore new and relevant topics. His suggestion to write about this particular case was driven by his belief that it would greatly benefit other investors in Australia. His enthusiasm and proactive approach have undoubtedly enhanced the value of our content, making it more applicable and helpful for our audience. Thank you, Shan, for your ongoing support and for motivating us to share your personal investment insights with the broader investment community.

Overview – Shan and Zan, after years of thriving in their respective careers, have embarked on a journey towards potentially early retirement in their forties, underpinned by a thoughtful transition to living off their property portfolio. Their decision to take a career break was followed by overseas travels, a period of reflection and exploration that ultimately led them to reassess their investment strategies. As part of their strategy, they have moved into one of their investment properties, held in a Trust, which is now listed for sale.

This move, prompted by the current rental market crisis, positions them in a unique scenario where they must navigate the complexities of property management and financial planning, particularly in relation to the deductibility of various property related expenses during their stay in the property.

Their strategy to move into their rental property, owned by their family trust, raised some unique questions that many taxpayers seek answers to. For instance, can Shan and Zan claim Council, Water, Electricity, and Gas usage as expenses during their stay in this property? This is considering that these services must be in working condition, whether they live in the property or not, to conduct building and pest inspections. Would it be different if the property were in an individual’s name rather than a trust?

Non-Deductible Expenses

Queries and Answers – Let’s tackle the first question: What expenses can I claim when the property is on the market for sale? The answer to this question is that since the property is not earning rental income or available for rent, none of the expenses will be part of an immediate deduction in the tax return. However, some of the expenses will be included in the cost base calculation.

What is a Cost Base? – The Cost Base of a Capital Gains Tax (CGT) asset typically includes the purchase price of the asset, along with certain additional costs related to acquiring, holding, and disposing of the asset. The cost base is comprised of five key elements:

  1. First Element – Acquisition Cost: The amount of money paid to acquire the asset is considered the acquisition cost. In cases where money is not exchanged, the market value of the property given to acquire the asset is used instead.
  1. Second Element – Incidental Costs: Costs incurred in acquiring the CGT asset, or those related to the sale of the CGT asset, include incidental expenses. In terms of property transactions, the incidental costs of acquiring properties include legal fees, stamp duty, and buyer’s agent fees, among others. Meanwhile, the incidental costs associated with selling the property encompass advertising fees, agent commissions, and tax agent fees, especially if professional advice was sought for acquiring the property.
  1. Third Element – Ownership Costs: These are non-capital costs associated with owning the asset. This element is the most important of all. Many of us are aware of the first and second elements; however, not as many are familiar with this element, which some accountants consider their trade secret. Generally, when your investment property earns rental income, you claim these expenses against the rental income as an immediate deduction in your annual tax return. However, when you are not earning rental income, you can include these expenses as part of the property’s cost base.

Examples of these non-capital expenses include rates, land taxes, repairs, and insurance premiums. They also include non-deductible interest on your loan. For instance, if you reside in one of your investment properties, irrespective of whether it’s held in a trust or owned personally, the interest payments made during this period can reduce your capital gains tax liability by becoming part of your cost base.

However, it’s important to note that if the property is personally owned and you’re claiming a Principal Place of Residence (PPOR) exemption while living there, these expenses cannot be claimed. This distinction is crucial for property investors to understand in order to navigate tax implications effectively.

Important notes about this Element – 

  • You can include non-capital costs of ownership only in the cost base of assets acquired on or after 21 August 1991.
  • These costs cannot be indexed or used to work out a capital loss.
  • Do not include the expenses if you have already claimed them as tax deductions against your rental income in your annual tax return.
  • According to the ATO example, it seems that only holding costs can be claimed as the third element of the cost base. There is no mention of supply charges in the ruling, so supply charges may not be included in the cost base of the property.
  1. Fourth Element – Improvement Costs: Capital expenditures incurred to enhance or maintain the value of your asset, or to install or relocate it, are significant. For example, if you have undertaken landscaping work, added a pergola, or included a carport on your property, these improvements are aimed at enhancing the property’s value.
  1. Fifth Element – Costs of Preserving or Defending Title: Capital expenditures for preserving or defending your ownership of or rights to your asset.

To illustrate a Capital Gains Tax (CGT) calculation using the above element, let’s use Shan and Zan’s property trust transaction as an example:

  1. Purchase Price: They acquired the property in 2015 for $500,000.
  2. Acquisition Costs: The stamp duty and legal fees associated with the purchase amounted to $28,000.
  3. Buyer’s Agent Fees: They employed a buyer’s agent for the acquisition, costing $12,000.
  4. Selling Price: The property was later sold for $850,000.
  5. Selling Expenses: Real estate commission fees were $16,000, and advertising and legal fees for the sale totalled $6,000.
  6. Interest During Stay: While living in the property for 3 months, they incurred $6,000 in interest on their loan.
  7. Ownership Costs: During their stay, they also paid $500 in rates and $6,400 in land tax.

Now, let’s break down the CGT calculation:

Cost Base Calculation:

  •  Purchase Price: $500,000
  • Acquisition Costs: $28,000 (stamp duty and legal fees)
  • Buyer’s Agent Fees: $12,000
  • Ownership Costs While Living There: $6,900 ($500 in rates + $6,400 in land tax)
  • Loan Interest During Stay: $6,000
  • Total Cost Base: $500,000 + $28,000 + $12,000 + $6,900 + $6,000 = $552,900

Capital Gain:

  • Selling Price: $850,000
  • Selling Expenses: $22,000 ($16,000 in real estate fees + $6,000 in advertising and legal fees)
  • Net Selling Price: $850,000 – $22,000 = $828,000
  • Capital Gain: $828,000 – $552,900 = $275,100

In this scenario, capital gain for the sale of the property owned by the trust is $275,100. The trust will receive a 50% discount on capital gains, as the property has been held for more than 12 months.

In conclusion, the journey of Shan and Zan through the maze of property investment and Capital Gains Tax (CGT) calculation underscores a vital aspect of financial planning and tax optimization. Their story illustrates the complexity of leveraging non-deductible expenses to minimize CGT liability and the nuanced understanding required to navigate such a landscape effectively. As we’ve seen, the calculation of the cost base and the subsequent determination of capital gains involve several critical elements that can significantly impact the final tax obligation.

In this case study, we haven’t covered information on the reduced cost base because the focus is primarily on the elements of cost. Shan and Zan’s situation do not involve the reduced cost base element. It’s essential to recognize that each investor’s situation is unique, influenced by various factors including the type of property ownership, the duration of stay in an investment property, and the specific expenses incurred throughout the ownership period. Given these complexities, and the potential for significant financial implications, it’s prudent to seek expert advice tailored to your specific circumstances.

If you’re considering selling an investment property or wish to better understand how your personal expenses could influence your CGT calculations, we strongly recommend consulting with a tax specialist. At Investax, our team of experienced tax professionals is equipped with the expertise to provide you with personalised advice, ensuring that your property investment strategy is not only tax-efficient but also aligned with your financial goals.

Pro Tips- 

  1. Cost Base – Understanding the cost base elements of a property is crucial for minimising Capital Gains Tax (CGT) when selling an asset. The cost base includes investments in acquisition, improvements, and holding costs, which are subtracted from the selling price to determine the capital gain. Each element of the cost base not only reduces the taxable gain but also impacts cashflow planning and tax obligations. By strategically managing and documenting these expenses, property investors can significantly decrease their capital gains, leading to substantial tax savings.
  1. Holding Costs – As per S110-25(4) ITAA97, the holding costs are expenses that are directly related to the holding of the land and buildings. Some of the examples are: 
  • Interest on money borrowed to purchase the property. 
  • Costs of repairs and maintenance 
  • Insurance premium 
  • Rates 
  • Land tax. 
  • Interest on money borrowed to refinance money that was borrowed to originally acquire the property; and 
  • Interest on money borrowed to finance capital expenditure to increase property value. 
  1. Supply Charges – Supply charges for a property generally refer to the costs associated with the utilities and services that make the property habitable and functional. These can include charges for water, telephone, internet, electricity, and gas. The purpose of these charges is to ensure that the property is liveable and comfortable for its occupants. There is no mention of supply charges being part of the third element, so they may not be included in the third element of the cost base. This is also backed up by a private ruling number 89722. However, as this is a private ruling, it cannot be used as blanket rule since it is specific to that taxpayer.
  1. Consult a Professional – When navigating the complexities of Capital Gains Tax (CGT) and property investment, professional guidance is not just beneficial; it’s essential. Tax laws are intricate and constantly evolving, making it challenging for even the savviest investors to stay updated. Consulting with a specialist property tax accountant can help ensure that your investment decisions are both tax-efficient and compliant with current laws. If you do not yet have a specialist property tax accountant, please feel free to consult with the Investax Tax Specialists.

Reference: – This ATO link is only available until 30 June 2024. After this date the ATO will remove this link.