Understanding Taxable Income from Property
Taxable income from property refers to the net income you derive from your investment property after deducting all allowable expenses. This includes rental income earned from tenants, offset by costs such as loan interest, property management fees, repairs, depreciation, and other eligible expenses. The resulting figure can either be a profit (positive gearing) or a loss (negative gearing), each having distinct tax implications.
Negative Gearing vs. Positive Gearing
- Negative Gearing: Negative gearing occurs when your deductible expenses exceed the rental income generated by your property, resulting in a net loss. This loss can be used to reduce your other taxable income (for example, your salary), potentially lowering your overall tax liability.
- Positive Gearing: Positive gearing happens when your rental income is higher than the total expenses, resulting in a net profit. This surplus is added to your assessable income and taxed at your marginal rate. While positive gearing means you’re earning extra cash flow each year, it also means a higher tax liability, as you must pay tax on that profit.
How the ATO Views Deductions and Income
The Australian Taxation Office (ATO) allows you to deduct all eligible expenses incurred in earning rental income. Whether these deductions create a loss (negative gearing) or a profit (positive gearing), they must be reported on your tax return
- For negative gearing, the ATO permits you to offset the net rental loss against other income, potentially reducing your overall tax bill.
- For positive gearing, the surplus is added to your taxable income, increasing your tax liability for the year.
Taxable Income = Positive Gearing – Negative Gearing
Where:
Positive Gearing = Rental Income + Capital Gains from Sale
Negative Gearing = Deductible Operating Costs + Land Tax + Deductible Interest & Fees + Depreciation + Capital Losses from Sale
Therefore:
Your subsequent Tax Benefit or Liability = (Property Taxable Income) * Your Effective Tax Rate
Example: Negative vs. Positive Gearing
- Negative Gearing Example: Sarah, a 32-year-old investor, owns an apartment that generates $18,000 in rental income for the year. However, her allowable deductions—including interest, property management fees, depreciation, and repairs—total $22,000. This results in a net rental loss of $4,000. Sarah can offset this loss against her other taxable income, such as her salary, potentially lowering her overall tax payable. Her strategy is built on the expectation that the property’s capital gains over time will eventually outweigh the annual loss.
- Positive Gearing Example: James, also 32, purchases a duplex that brings in $30,000 in rental income per year while his expenses total $25,000. This yields a net profit of $5,000. Although James enjoys positive cash flow, the $5,000 profit increases his taxable income and is taxed at his marginal rate. Positive gearing offers immediate income but requires careful planning to manage the higher tax liability.
Pros and Cons of Negative Gearing
Pros
- Tax Reduction: The rental loss can be offset against other income, reducing your taxable income.
- Potential for Capital Gains: Investors often accept short-term losses with the expectation that the property’s value will increase over time, yielding significant capital gains on sale.
- Enhanced Cash Flow Management: By spreading the cost of ownership over several years, negative gearing may allow investors to enter the market sooner with a smaller deposit.
Cons
- Ongoing Cash Flow Deficit: Negative gearing means you are paying out more in expenses than you receive in income, which requires additional cash outlays from your own funds.
- Reliance on Future Capital Gains: The strategy hinges on the assumption that property values will rise, which may not always be the case.
- Increased Borrowing Risk: Accumulating losses and additional debt can increase your financial risk, especially if market conditions change.
Unseen Complexities: Renting Part of Your PPOR: One Bedroom or Granny Flat
Before you rent out part of your Principal Place of Residence (PPOR)—such as a single bedroom or a granny flat—it’s important to be aware of the tax implications, as they differ from those of a pure investment property.
We have summarised the key concepts and considerations below, however it is advised to seek professional advice.
Rental Income and Expenses
Before you rent out part of your Principal Place of Residence (PPOR)—such as a single bedroom or a granny flat—it’s important to be aware of the tax implications, as they differ from those of a pure investment property.
We have summarised the key concepts and considerations below, however it is advised to seek professional advice.
Impact on CGT Exemption
Renting out part of your PPOR for any period of time can affect the capital gains tax (CGT) main residence exemption.
The rented portion may not qualify for the full CGT exemption when you sell your home. Instead, you might have to calculate a partial exemption where the capital gain is apportioned between the rented and non-rented areas.
If you elect to rent out a room or granny flat in your PPOR, you must:
1.
Accept that you are foregoing a full CGT exemption
2.
Check whether the property satisfies the ‘Home First Used to Produce Income’ rule (Section 118-192 ITAA 1997), which requires that:
- The property can only qualify for a partial exemption because it has been used to produce income
- The property would have otherwise qualified for a full exemption had it been sold just before it was used to produce income, and;
- The property was first used to produce income after August 20 1996.
3.
If these conditions are met, you will need to determine the market value of the property at the time it was first used to produce income. This is important as it becomes the new cost base (“reduced cost base”) for the CGT calculation (learn more in Lesson 7).
- Note – any costs incurred before this time cannot be included in the reduced cost base.
- It also resets the ownership period for main residence exemption purposes and for the CGT discount (learn more in Lesson 7).
4.
Accept that you will now be liable for CGT proportional to the % of the internal floor space (IFS) that was rented out.
Example
If a granny flat (or a rented room) makes up 20% of your property, you may be liable for CGT on 20% of the capital gain (based on the reduced cost base formula), while the remainder could still be exempt if the property qualifies as your main residence for that portion.
Practical Consideration:
This arrangement means you need to maintain clear records and accurately measure the rental portion to correctly apportion income, expenses, and eventual CGT liabilities. It’s advisable to consult a tax professional to ensure you comply with ATO guidelines when part-renting your PPOR.
