Avoid these common mistakes when you are buying a rental property

Property Investment - Competent - 700 Words - Reading Time 5 Minutes

When you own a rental property you will want to take advantage of the help you get from the tax deductions associated with negative gearing. And one of the biggest expenses to claim as a tax deduction is the interest on the property. However, over the years, I have seen a lot of investors get the structure and use of their loan wrong and as a result they end up with a loan and a big interest bill every year - but no tax deduction for it.

Over the next few blogs, I will explain some of these mistakes so you can ensure that you can avoid them and get the maximum tax advantage on your investment property. It is important to understand that it is how you use the proceeds of the loan that determines the tax deductibility. Keep this principal in mind and it will help you keep your loan interest deductible.

Mistake No 1: Using the funds to buy your own home.

This is a common mistake where people have paid off their own home and are going to move. In the process, they also decide to keep their existing home as a rental property. Many people assume that if they refinance their existing house and use it as the security for the loan, the interest will be deductible when they use it as a rental property. However, this is not the case. The security is not relevant - it is the use of the money that determines if the interest is tax deductible - and in this case they are going to use the money to buy their new house. This is not a tax deductible purpose and therefore the interest on the loan is not tax deductible.

For example, John owns his house in Melbourne and has paid off the mortgage. He gets a job transfer to Adelaide and decides he would like to keep his Melbourne home as a rental property. John gets a loan using his Melbourne home as security. However, he uses the proceeds of the loan to buy an Adelaide house to live in. Unfortunately, the interest on John’s loan will not be tax deductible, because he used the money to buy his new home. This leaves him in a difficult situation. On the one hand he is receiving rent on his Melbourne property and he will be paying tax on that income. On the other hand he is making repayments and paying interest on a home loan but not getting any tax deduction for it.

This situation is not always easy to solve, but you may be able to do something about it if you are careful in the planning stages. Sometimes, it can be better structured at the start of the loan by changing the ownership. For example, if John was married to Maree, and the Melbourne home was solely in her name, John could borrow to purchase the home from Maree and in that case would have a tax deductible loan. Maree could then use the proceeds from the sale of the Melbourne property to buy the new home in Adelaide.

This leaves John owning the Melbourne property with rent coming in but also deductible loan interest to offset the tax payable. The new home in Adelaide has no loan against it.

There may be some tax consequences in this type of restructure. However, if the Melbourne property has always been John and Maree’s  main residence, there will be no Capital Gains Tax and it will also be exempt from stamp duty as the property is in Victoria and the transfer is between spouses.

Please note: This document has been prepared for the purpose of providing general information, without taking account of any particular investor's objectives, financial situation or needs. It does takes into account Australian Taxation Law that was in place as at October 2013. Before making any investment decisions, you will need to consider if the information in this document is suitable for you. You may want to ask a financial adviser to help you.