Invest Wisely, Pay Less. How property can reduce your tax?
The first thing to understand is that the rent you receive from a property actually increases your tax. On the other hand, all the expenses associated with holding the property, including the ever-so-valuable ‘depreciation’ are tax deductible, reducing your taxable income. This results in you getting a tax return.
Let’s put it into practice…
For this example, let’s say you earn $100,000 per year. Let’s also say you own an investment property worth $575,000 with a $517,500 mortgage. You rent the property for $590 per week (or $30,680 per year). Firstly, the ATO will add the rent received to your income. This makes your income $100,000 + $30,680 = $130,680.
Figure 1. Income earned from wages and rent*
At this stage, if you had no deductions to subtract, you would be liable to pay tax on the extra $30,680 you received from rent. Fortunately, you will have plenty of deductions to cancel out the rent received and take your “on paper” taxable income below what you have already been taxed on.
Now, let’s take a look at the other side of the coin: your deductions.
Deduction 1: Interest and bank fees
The first deduction is the interest and bank fees on your $517,500 loan. At 6% interest the yearly interest would be $31,050.
Deduction 2: Rental management fees
The next deduction would be the management fees your rental manager charges. Let’s say they were taking a percentage of the rent and a letting fee (8.8%) to a total of $3,068.
Deduction 3: Insurance, rates, maintenance & miscellaneous
Next you have insurance at $1,200 (this would include building insurance and for landlords’ insurance), rates at $2,000, and maintenance at $600. This gives you a total of $3,800.
These expenses are what we call ‘cash deductions’ as you use real cash to pay for them. These deductions come to a total of $37,918 per year.
Deduction 4: Depreciation
Finally, you have possibly the most important deduction: the depreciation. This is what we call an ‘on-paper deduction’ since we are not spending real cash on it and the house didn’t actually go down in value. For this example, let’s use a round figure of $20,000. This is the secret sauce of property investment and why I always recommend buying a new property.
Let’s add up your total deductions:
$31,050 (interest & bank fees)
+ $3,068 (management fees)
+ $3,800 (insurance, rates, maintenance, etc.)
+ $20,000 (depreciation)
= $57,918
Whilst the rent increased your taxable income to $130,680, the $57,918 in deductions has brought your income back down to $72,762 on paper in the eyes of the tax office. As such, because you paid tax on your original salary of $100,000, and should have only paid tax on
your taxable income of $72,762, you are due a refund!
Figure 2. Calculating new taxable income after deductions*
Going back to our tax tables, someone earning $72,762 would fall into the 32.5% tax bracket. Therefore, the total tax paid should be:
$5,092 plus 32.5 cents for each $1 over $45,000
= $5,092 + $0.325 * ($72,762 – $45,000)
= $5,092 + $0.325 * ($27,762)
= $14,114.65
Figure 3. Calculating your tax return*
So if you paid $22,967 tax (on $100,000) and should have paid only $14,114.65 tax (on $72,762), the tax office owes you a $8,852.35 refund!
Now of course, we am not an accountant and the area of taxation is something that is constantly changing, so you should always speak to your accountant first before making any decisions on
the basis of how they will benefit your tax situation.
Income versus expenses for your investment property will like this:
$30,680 (rent) +$8,852 (tax return)
= $39,532
– $37,918 (expenses)
= $1,614 (profit)
You’ll have a $1,614 profit for the year – that’s $31 of passive income per week. Remember this amount will also increase every year as the rent climbs. What could you buy with an extra
$1,614 a year? You might take your family on holiday or lease a nicer car.
What the wealthy understand is that you have two forms of income – your work income from your job and your passive income from your investments. You’ve got to respect your work income because you work hard for it. It’s precious and you don’t want to waste it. With that income you’re paying for necessities – putting a roof over your head, food on the table, keeping the lights on – and investing the rest.
Then your passive income is your fun money. It’s okay to spend it on fun stuff like flash cars and holidays, since it will keep coming back again whether you work or not. This is what wealthy people teach their kids: buy real assets that build a passive income stream. That’s why they have flash cars and boats and take holidays four times a year. It’s very important to make this differentiation and respect your work income.
Come back for the next important lesson in Mastering the Property Game!
~Integrity Team
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