I had a call the other day from a client who was worried that their superannuation balance has taken a hit, and that all the additional super contributed had effectively been lost.
I gave assurance that an approved super fund will invest in assets that have a base asset value that will return to its former value as the market adjusts to the event(s) that have caused the fall in value. It is not a loss until the investment is sold or realised and until this happens, the investment remains an unrealised loss (gain).
My client had’nt lost his super. It was temporarily impacted by market forces. It nevertheless highlights the need to plan for outcomes, and not be surprised when they happen.
This raised another financial issue that is in the press today. Interest rates and how the dramatic increases in recent times are impacting family budgets.
To those in the know, this latest set of RBA adjustments was always going to happen. Unfortunately the desire to own the best possible home outweighs financial prudency every time. Our natural inclination is to be optimistic in allowing for future changes. We tend to assume that it will all be OK and that we will find the money if things go ‘pear shaped’.
Well things have gone ‘pear shaped’ and those with a mortgage are paying a lot more in interest on the loan that was negotiated less than 12 months ago.
The ‘salt in the wound’ is that this interest is not tax deductible. The family home is a personal asset that has no connection with income that you earn as a salary or otherwise.
So what can we do about this cost imposition that is beyond our control?
The short answer is not much.
However if we get creative and think about the family assets and financial situation, we may be able to ‘pay’ for the increases through legitimate tax saving measures.
Before we start I must remind the reader that if the interest that you are paying is on your primary residence, then on the sale of that residence, you will not be liable for capital gains tax. If you use the residence in any way to generate income, then you may be liable for capital gains tax for the period in which it was used to produce income. The tax calculation is based on the proportional area of the property used to produce income and the time period used to produce income. (there are rules that I have written about previously in Tax Me).
This being said, don’t be deterred from looking at ways to pay for your increased interest bill.
Granny Flat/AirBnB
What is deductible?
A proportional share of all costs of running the business. This includes loan interest, rates, maintenance of the rental area, supplies, depreciation of capital items like beds, kitchens, white goods.
General rule is that depreciable items must be new or substantially renovated.
Whats not deductible?
The capital cost of aquiring/establishing the rental property and associated landscaping is not deductible at purchase. This can generally be claimed over 40 years or the life of the asset.
Granny staying in the property and not paying a market rate of rent does not constitute a rental property . There must be income generated before expnses can be deducted.
Home Office
The trend is that more and more people now work from home. A home office is tax deductible but the rate of deductibility depends on how often and how it is used.
The rules are much the same as for the Granny Flat/AirBnB option above, including the liability for capital gains tax. Generally speaking if you do not claim interest or rates, then capital gains tax liability is unlikely. However this negates the possibility to substantially pay for your incresed interest bill.
Capital Gain Tax explained
If you claim a proportion of your property costs as a deduction against revenue generated from that proportion, then on the sale of the property you must pay capital gains tax on profits made on the sale.
This may not be as bad as you think, but you should factor this cost into your planning.
Example
You bought a property in July 2000 and sold it in June 2020 and all or some of the property (15%) was used as a rental property during that period for a total of 4 years. You claimed all operational costs of the property including interest and rates for the period that it was receiving income as a rental property. The property and additions cost $1.5 m and you sold it for $4m. Your capital gain less any sales costs was $2.5m. The time period used as a rental was 20% of the time period owned. You will be liable to pay tax on a capital gain of $75,000 at your marginal tax rate. (2.5m*20%*15%).
If your marginal tax rate was 47%, then your tax bill would be $33,750.
N.B. The actual capital gains tax is based on the difference between the market value of the property at the point at which it commenced to be used as a rental property and the point at which it ceased to be used as a rental property. For the purpose of this example this has been ignored, but in reality the capital gain could be significantly less.
You may be thinking how is the taxman going to know? Well let me assure you that the chances of the ATO catching you out if you fail to disclose can be quite high and it is getting higher. Currently the ATO is aware of all property sold and you must claim for CGT exemption as a primary residence in your tax return for the entire peroiod of ownership. Be careful but more importantly be aware of the CGT trap and factor it into your planning.
In Summary
Interest paid on your home loan is not tax deductible.
If you use all or part of of your property to produce rental income then you can claim a proportional share of all running costs on the rental property (including loan interest).
If the property is your primary residence and it (or part of) is rented during the period of ownership, the rental portion ceases to be CGT exempt for the period it remains a rental and you will be liable for CGT on a notional capital gain calculated for the rental period.