The ultimate guide to property investment accounting - know your return
There are a lot of things that go into successful property investment. However, one element that is often overlooked is the accounting side of things.
Property investors who understand the advanced concepts of property investment accounting can make more informed decisions about their investments and maximise their returns.
Here you can explore some of the more complex aspects of property investment accounting and how they can benefit you as an investor. So if you're ready to take your investing skills to the next level, keep reading!
What is property investment accounting?
Property investment accounting is tracking and managing the financial aspects of your property portfolio. It includes recording income and expenses, calculating tax liabilities, and preparing financial statements.
It's important to keep on top of your property investment accounting. It will give you a clear picture of your financial situation and help you make informed decisions about your investments.
Things to consider during investment property accounting
Here are some considerations that you should follow while accounting for an investment property.
- The acquisition should be investment-driven and not tax-driven.
- Property is an investment that pays off over time. With this in mind, seek counsel from a tax professional on how to organize the ownership.
- Consider your situation before deciding whether or not an interest-only loan is good for you.
- A property in a favorable location without non-cash deductions may produce a greater long-term return than one in a less affluent or profitable location with non-cash deductions.
- The benefits of hiring a real estate agent to handle your property should exceed the disadvantages.
Real estate income tax returns
For instance, rental income is considered taxable, but you can make many deductions against this. It includes -
1. The settlement statement
Your solicitor will provide you with this statement when you finalize the property. It would need to be retained for at least five years after selling the property or until a loss could be offset against an assessable capital gain for five years.
This statement contains the following information:
- The acquisition date
- The price
- Other purchase-related expenses include solicitors' fees, search fees, and stamp duty.
You can include the noted rates and the body corporate fees in the claims for permissible deductions.
2. The loan agreement
We use the loan document to keep track of the costs of borrowing. These are the fees associated with obtaining financing for the rental property.
You must carefully consider the way these are handled. If the sum is less than $100, it can be claimed in the payment year. If they exceed $100, they must be written off throughout the loan term or five years, whichever is shorter.
Borrowing costs include loan application fees, legal fees related to the mortgage, stamp duty on the loan, fees for document registration, title searches, mortgage registration, valuations, and mortgage insurance payments.
It is the time to record the income for tax purposes. The taxable income you generate throughout a fiscal year is subject to income tax returns. Your taxable income is equal to your assessable income minus any permitted deductions you took during that period.
Ordinary income and additional amounts specifically included in assessable income make up assessable income. Your rent is considered assessable income.
You must report the gross rent. Other payments (such as bond reimbursements for repairs, cleaning, or rent arrears) are a part of your taxable income.
You can return income for tax with one of these two methods -
- The cash basis of property investment accounting - Income acknowledges as soon as it is received.
- The accrual method of property investment accounting - Money acknowledges as it is earned.
We use the cash basis to report the rentals. It implies you must include rental revenue in the year it is received. If an agent receives the money on your behalf, you must report it the year the tenant pays them, not the year you get the check.
Because the agent is operating on your behalf, you are considered to have received the rent when they do.
Ensure you are claiming just the allowable deductions. Not all expenses are tax-deductible. It would help if you distinguished between costs defined as capital and costs defined as an expense.
The property must be rented or offered for rent for an expense to be deducted. The costs of preparing a rental property for the first time are not deductible.
The costs of promoting a rental property to find a tenant are deductible. The expenditures of advertising your home for sale are not deductible, but they will be deductible for CGT reasons.
So, if you pay your agent to publish a classified ad in the newspaper to find a tenant (or if you do it yourself), you can deduct the charges.
6. Commissions and fees paid to agents
The commission and fees paid to the agent are tax-deductible. It covers the commission paid to the agent, letting fees, and other fees. The agent will give you monthly statements that include these details.
7. Bank Charges
Suppose you have a bank account dedicated entirely to property transactions. In that case, you may be able to deduct the costs of maintaining a bank account for banking rent and paying rental bills.
Use the bank statements to extract charges and recurring loan costs (such as loan service fees), which are also deductible.
8. Computer cost
You can claim computer costs if you keep property records on a computer. But you must allocate private usage. To do so, keep track of the time the computer is used for rental and personal purposes.
A one-month record may be sufficient. Software acquired expressly for rental property accounting should be claimed in total.
It permits you to write off some of the cost of the plant used to produce assessable income in a given year. You can calculate depreciation for tax purposes in two ways:
- Depreciation is calculated using the prime cost technique as a proportion of the plant's cost.
- The diminishing value technique is based on the asset's initial cost and then a proportion of the depreciated cost for subsequent years.
Most real estate investors employ a diminishing value basis since it delivers a higher claim in the early years. It exploits the notion that a dollar today is worth more than a dollar tomorrow.
To claim depreciation, you must own the item of the plant. You can't claim the tenant's furniture.
10. Gardening and grounds-keeping
The costs of maintaining the property's grounds, such as grass mowing, garbage pickup, and tree lopping, are acceptable deductions.
Tax deductions are available for landlord insurance, public indemnity insurance, and the expense of insuring the property.
The loan statements gave the necessary information regarding interest paid during the year. You can claim the interest if you own your home and use it as collateral to buy a rental property.
You cannot deduct the interest on a loan used to buy your home. There will be no claim if you possess a rental property and borrow against it to finance your property.
13. Legal costs
Legal fees for drafting a finance lease, serving a tenant with demand, and adhering to a loan discharge can all be claimed. Legal fees for purchasing or selling a property are capital expenses that cannot be deducted.
14. Expenses for secretarial and bookkeeping services
Maintain records for your rental property, including revenue and expenses. When submitting real estate tax returns, you can claim this income.
GST in property investment accounting
What is GST?
GST is a value-added tax levied on the consumption of most goods and services. Rental properties are considered taxable supplies for GST purposes, so landlords must charge GST on their rent.
However, you can claim many expenses as deductions against this.
The tax will have little impact on residential property investors' compliance needs than increasing non-financial expenditures. Commercial property owners face a unique set of challenges.
Residential Properties - Construction of new residences and renovations are subject to GST. Private sales of property are exempt from GST. Residential rents are subject to GST if the lease does not exceed 50 years. These rents are input taxed if the lease is less than 50 years.
The term "input taxed" refers to the lack of a credit for taxes paid on products or services provided.
Input taxes apply to costs incurred in a residential rental property operation.
It implies that an investor cannot claim a tax credit for repairs, body corporate fees, rates (except water and sewerage), insurance, etc. But not for commercial properties.
Only the apartment will be input taxed if an investor owns a building with a shop on the ground floor and a flat above. GST will apply to the store.
Commercial Properties - Merchandise & non-residential land and buildings are taxed when built, sold, or rented. It applies to both new and utilized properties.
The owners of these properties are only tax collectors, as they can deduct the tax levied from the tax collected. They must, however, remit the GST charged to the Commissioner of Taxation on time.
As a result of the GST, owners of residential rental properties have had to either accept a lesser return on investment or raise the rent. It is not the situation with commercial properties.
The owner receives the tax from the business owner, who then credits the tax paid against the tax collected from the items supplied to customers.
Unregistered persons are not obligated to charge GST on supply and cannot receive credits for GST paid on purchases. Interest, water, and sewerage charges are not subject to GST.
CGT in accounting for investment properties
CGT is Capital Gains Tax, a tax on the profit you make when you sell an asset. For property investors, this includes any profits made from selling investment properties. CGT is calculated on the difference between the sale price and the original purchase price, minus any costs associated with buying or selling the property (such as agent's fees).
If you decide to sell one or more of your investment properties, you must understand the ramifications of CGT. Capital gains are only taxed if they exceed capital losses for the year.
In brief, subtract the purchasing cost from the sale price. However, there are adjustments for capital gains, such as depreciation, agent commissions, and property upgrades. If you own a property for 12 months or more, any gain is lowered by 50% for individuals and 33.33% for superannuation funds.
Capital losses can be adjusted against capital profits and carried forward forever. Property held as an investment comprises houses, flats, vacation homes, retail stores, and land. Your primary residence is exempt from CGT.
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How to calculate CGT for a property sold?
The CGT calculation is based on the property's sale price minus your expenses.
The cost base is the initial asset price minus any incidentals, ownership and title charges, and depreciable goods.
- Stamp duty, legal expenses, agency fees, and advertising and marketing fees are examples of incidentals.
- Ownership costs include rates, land tax, upkeep, and loan interest.
- Improvements are replacing kitchens, bathrooms, and any other modifications you've made to the property.
- Annual depreciation is the amount claimed throughout the ownership of the leased asset. Any unclaimed depreciation reduces this value.
After calculating the capital gain, you can adjust the figure for variables such as:
- The percentage of time you owned the property that was rented out.
- A 50% discount is applied if the property is held for more than 12 months.
Capital gains tax calculation example
If a CGT event occurs before or after 12 months of ownership, the table below shows two scenarios with distinct effects.
In this scenario, a $450,000 investment property is purchased and eventually sold for $600,000. We'll suppose the reported depreciation is $8,000. The tax rate of 30% has been applied.
CGT will vary depending on the conditions of each instance and the investor's circumstances. It is highly suggested that you consult an accountant regarding the effects of CGT and the exemptions available when selling an investment property.
How can depreciation on property investment impact your taxes?
The reduction in the value of property assets over time is known as tax depreciation (also known as property depreciation). It is a valid deduction from taxable income earned by a residential or commercial investment property.
Two techniques are acceptable to pay tax. These are declining value and prime cost.
It estimates depreciation as a percentage of the depreciated value. The prime cost approach computes depreciation as a % of the cost.
The decreasing value basis provides the benefit of allowing a bigger deduction in the first years, resulting in lower tax. Except for part-year claims, the prime cost technique allows for an equal write-off each year.
To depreciate an item, the taxpayer must own it.
Calculation of Depreciation
We calculate the claimable depreciation by the following formulas -
The formula for Diminishing Value Method
The formula for Prime Cost Method
Risks and Pitfalls
(a) if the rental property's value decreases, your losses may surpass your other income, resulting in a net loss,
(b) if the property is vacant or tenants do not pay rent, it may impact your financial status.
Liquidity risk exists if you want to sell your investment property. Without a buyer, you'll have to hold onto your investment or lower the acquisition price to attract a buyer, which will incur significant losses.
Personal circumstances might impact your real estate investments, especially if you use negative gearing as an investing strategy. Your financial situation may alter due to the loss of a job or business or illness.
You will find several property owners who lose a lot of money, especially during a recession. It's best to positively gear a real estate investment, which means subtracting tax benefits and depreciation from the rental revenue to get a positive cash flow.
Positively geared property is hard to come by, and building a real estate portfolio takes longer if you have to wait for your other assets to appreciate.
Bookkeeping and recordkeeping in property investment accounting
Do you keep books and records to support your tax claims? While keeping records for tax purposes is important, real estate investors require much more. They rely on reliable bookkeeping systems to ensure trend analysis and cash flow forecasts.
The significance of an audit trail and verification necessitates keeping books.
The audit trail refers to the bookkeeping system and how you may track the transactions in accounting.
The audit trail refers to the bookkeeping system and how you may track the transactions in accounting.
The verification procedure starts with a final number on a financial statement and works backwards. That final figure is most likely the aggregate of several entries made throughout the year, each based on a single bank deposit, cheque, cash payment, or journal entry.
As a result, anyone looking at the final stage—the financial statement—should be able to verify information back to the source document—a receipt, deposit slip, contract, or other proof of that.
- the transaction occurred
- the amount is correct
- the transaction is business-related.
The figure below summarizes the audit trail.
- The final step, the financial statements, contains just summary data.
- The general ledger collects monthly account entries.
- Journals are collections of specific entries. There are four types of journals.
Obligation to keep record
The Tax law demands that you keep documents that detail your rental property transactions. It would help if you kept them -
- Either in writing or computer format, you should keep it in English only.
- So that you can easily determine your assessable income and permitted deductions.
- For five years after the invoice is issued or the completion of the transaction costs.
These records include your rental income and expenses and your rental property's acquisition or sale paperwork. The records must be produced if asked, even if they are not needed to be filed with your income tax return.
Leveraging in real estate
Leveraging occurs when you borrow money to fuel investment. Real estate is the only investment that allows you to leverage your borrowings readily.
Some lenders will even approve a loan with only a 10% deposit. You can deduct the loan interest and most property expenditures from your taxable rental income if you borrow money to buy an investment property.
If your property is available for rent, you can deduct the interest you paid on any loans you took out to buy, renovate, or deal with tenants.
The type of security used to secure the loan has no bearing on the interest deduction.
For example, securing your investment property loan with your home does not affect the interest tax deduction. However, the tax deduction is only possible if the borrowed funds are utilized to pay rent. If the funds were used for personal and business purposes, the tax-deductible amount would need to be apportioned.
Deductions for interest on mortgages and loans for rental properties are limited to the interest on the rental property. Similarly, if you take a loan to buy a property that is utilized for both rental and personal purposes, only the rental interest is deductible.
Most people buy their own home first, and then when their equity grows, they take out another loan to buy investment properties. They maximize the loan on the investment property to take advantage of the tax deduction on the interest charged.
Negative vs positive gearing
Before accounting for property investment, consider whether you want to negatively gear (create a capital growth real estate) or positively gear (create a cash-flow real estate).
Both techniques have benefits and drawbacks, and which one you choose will depend on your unique circumstances and investment approach.
Negatively geared property
Negative gearing is often called "capital growth property." Buying a property with the expectation that it would appreciate over time. If you are in a higher tax bracket, the investment-related loss can be adjusted against other taxable income, lowering your tax bill.
If you choose this technique, look for an investment property in a stable, high-growth location near capital cities, which tend to do better over time.
Advantages of negatively geared property
Tax Deductions: Allowing investors to claim tax deductions for leasing expenses minimizes your rental deficit and thus your taxable revenue.
This is by no means an exhaustive list of what you can claim.
Before submitting your return, it is strongly advised that you seek professional assistance from a tax specialist.
- Tenant advertising, agent fees, and commission
- Payments of interest, loan fees, and bank fees
- Strata fees, land tax, and council rates
- Depreciation of appliances, including stoves, refrigerators, and furnishings
- Maintenance, repairs, pest control, and gardening
- Insurance for buildings and landlords
- Body corporate (owner's corporation) expenses and charges include stationery, phone bills, and any travel to check the property.
- Fees and costs for legal and accountancy services Government-imposed land taxes
- Postage and stationery
- Travel for the purpose of inspecting or maintaining the property or collecting rent
- Charges for water
- Improvements and capital works
Remember that there are some expenses for which you cannot claim a deduction: property acquisition and disposal costs, expenses not incurred by you, such as electricity charges paid by your tenants, expenses not related to the rental of a property, such as expenses related to your use of a vacation home borrowing expenses or interest on the portion of the loan you use for private purposes, such as buying a new car.
Capital Growth: To build wealth for investors, a property's capital returns must eventually balance the borrowing and costs.
Rental growth: As you raise the rent, the rental income exceeds the costs, resulting in a cash flow positive investment or a positively geared real estate.
Positively Geared Property
You have positive gearing when you collect more rent from your renters than you put out in loan repayments, property maintenance, rates, and other connected real estate expenses. Because the cash balance travels directly to you, this investment is known as a 'cash flow property.'
Advantages of positively geared property
Increased income: As an investor, you will benefit from increased revenue from the real estate, allowing you to pay down your mortgage faster and retire sooner.
Less financial risk: If your financial situation worsens, the investment's income will meet the costs, and you won't be forced to sell under duress under unfavorable conditions.
Increased real estate portfolio: With the extra income and value, you can buy one or two investment properties to add to your portfolio or use them to balance off negatively geared investments.
Attractive to banks: Your bank would be pleased to help you with another loan to buy other investment properties in the future since your track record of reducing the mortgage displays solid financial planning and credibility.
Tax implications of overseas property investment
Investing in overseas properties has been more popular among Australians since the advent of the Internet. More Australians are looking to invest in property in Europe, North America, New Zealand, Asia and other nations with strong property markets.
Many believe these countries' properties are now undervalued and offer good value for money. If you are an Australian resident, you must report all foreign income on your tax return. Listed below are some crucial considerations to consider when investing.
The Australian tax system compels you to provide information about your overseas property investments. Your tax return must include rent, costs, and capital gain or loss if you sell the property.
The ATO may penalise you heavily if you fail to provide this information. Therefore, it is best to declare your interest.
Rental income tax
Any overseas income you receive, such as rental income, is assessable in Australia unless an exemption exists. The exemption applies if your overseas rental property is in a DTA country. It implies you won't have to pay tax there.
You may be eligible for a foreign tax offset (FITO) or credit if you've already paid foreign tax on your overseas property income. The 'foreign source income and foreign assets or property' section include rental revenue from foreign properties.
Any expense made to generate rental revenue from an overseas investment property is tax-deductible. Deductions include property tax (rates in Australia), insurance, interest, maintenance, real estate agency fees, and capital works.
To lower the assessable rental revenue, these costs may be depreciated or claimed as a building allowance. Remember that what is tax-deductible in Australia may not be in other countries. So, you should hire a local accountant to help you with this.
Negative gearing relates to foreign property investments. From July 1, 2008, net foreign losses can be deducted against Australian revenue. If the overseas loss is not used, it can be carried forward forever to offset future revenue, whether from Australia.
Capital gains tax (CGT)
The DTA between Australia and the country where the property is located will decide the tax on any capital gain. The DTA may grant one country exclusive taxing powers or allow both countries to tax capital gains.
The CGT requirements for overseas investment property are comparable to those for Australian properties. You must report any overseas property sales or capital losses on your Australian tax return.
On your tax return, fill in the 'Capital gains' box. Use the capital losses to offset capital gains. An offset or credit may be available if you've already paid international tax on your capital gain.
There are no Australian exchange controls on monies transferred overseas but verify with the local authorities to ensure you comply with the country's domestic exchange control rules.
Before calculating your net income, you must convert any international income, deductions, and taxes into Australian dollars.
The Australian tax system is complex and unique to each country. It is best to seek professional guidance before investing in a foreign property to understand the ramifications fully.
Taxation for foreign investors
Australia's property industry has attracted and continues to draw foreign investors. Australian property is comparatively stable with robust growth compared to other global property markets. Australian property values have performed substantially better overall compared to other wealthy countries.
A foreign investor is defined as a person who is not an Australian resident (non-resident/foreign national) who purchases the property, a business, or a corporation in which he owns 15% or more of the property, or more than one foreigner owns 40% or more of the property jointly.
A foreign investor or buyer typically fits into one of three categories:
- A foreigner having permanent residency in Australia who wants to acquire an Australian investment property
- A foreigner or non-permanent resident wanting to buy an Australian property
- A non-resident foreigner is looking to buy Australian property.
Tax exemptions and restrictions
Foreign investors purchasing property in Australia must first receive approval from the Foreign Investment Review Board (FIRB). The FIRB is an Australian government agency that oversees the sale of Australian property to foreigners.
Without an exemption, foreigners purchasing residential or commercial property in Australia must obtain FIRB approval, regardless of the property's value or the purchaser's nationality. Some acquisitions, however, are free from FIRB approval. Some examples:
- A Kiwi buying a home in Australia
- A foreign national buying a house as a joint renter with an Australian citizen spouse
- a new home offered by a developer with previous approval to sell to a foreign national
- A foreigner purchases an interest in constructed commercial property for immediate industrial or non-residential commercial usage.
If you are a foreigner buying property in Australia, you must determine your tax residency status. Tax residency requirements are complex and differ from immigration residency rules. You may be treated as an Australian tax resident.
If you are a tax resident in Australia, your international income is normally taxable in Australia. Otherwise, only income earned in Australia is taxable, and most overseas income is not, although you will be subject to Australian income tax and CGT on any Australian taxable property you possess.
Also, you must implement any Double Tax Agreement (DTA) Australia has with your place of residency.
If you are a foreign resident and earn rental income in Australia,
(a) Obtain a tax ID number
(b) File a tax return in Australia.
As a taxpayer, you must report the rental income and can deduct several related expenses. If you sell your Australian property, you must pay capital gains tax.
Property investment accounting requires you to take advantage of the ATO's tax breaks. Real estate investment has certain distinct tax advantages over other investments; therefore, taking advantage of these tax benefits will help you maximize your investment return.
The idea is to use negative gearing, deductions, and depreciation allowances to leverage your asset and increase its value over time.
Real estate investment has many potential tax benefits, but there are certain risks to avoid. If you sell your property, you must consider CGT. If you own real estate, engage closely with a qualified real estate accountant who can advise you on tax difficulties specific to your financial situation.
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How do you account for borrowing costs when investing in real estate?
Borrowing costs are important to consider when investing in real estate. There are a few different ways to account for borrowing costs, but the most important thing is to make sure that you include them in your calculations.
One of the easiest ways to account for borrowing costs is simply adding them into the property's buying price. It will increase the amount you have to borrow, but it will also give you a better idea of the true price of the real estate.
Another way to account for borrowing costs is to calculate them into your expected return on investment. It will give you a more accurate picture of how much profit you can expect to make on your investment.
How do you factor in depreciation when calculating your real estate profits?
There are a couple of different ways to factor in depreciation when calculating your real estate profits. The most common method is the diminishing value method, which considers the shortened lifespan of a property as it gets older.
So, for example, if you bought a property for $100,000 and it's now worth $90,000 after 10 years, you would factor in depreciation by subtracting $10,000 from your total profits. This method is generally used for properties expected to have a long lifespan, like houses or commercial buildings.