One of the most common things that people approach accountants about is tax, or rather, that they’re paying too much of it. How can they reduce it?
However, if your only goal is to reduce tax, that’s easy. There are plenty of ways to realise this, such as making most of your taxable income into a charitable donation (e.g. $200,000 taxable income, $180,000 donation to charity).
But this isn’t really a realistic approach. You may pay no tax in this manner, but you will also be without money. Tax deductions and tax savings do however require you to spend more money than you’d save. This would be fine, but only if that money was originally going to be spent anyway.
There are still a few areas of tax law that offer true tax savings. The best one of all could arguably be the depreciation allowed on buildings and plant and equipment in rental properties.
But why is that? Yes, you can buy a building, write it off (claim the remaining value as depreciation) and then pay tax when selling the building. But the advantage here is that you get a full tax deduction for the depreciation BUT only pay tax on half of the capital when you eventually sell the property.
If Peter is in the top marginal tax bracket and paying 47% on each extra dollar that he earns, he is also conversely saving 47% tax on each dollar he spends. Let’s assume that an investment property he purchases cost $1 million. From a quantity surveyor, he receives a depreciation report entitling him to $15,000 in special building write off, with another $15,000 in depreciation on his plant and equipment.
In the first year of ownership, Peter should receive a tax deduction for the $30,000 in building write off in depreciation, which means that he should receive a tax refund of $14,100 on those expenses (47% of the write off). No additional money needs to be spent to receive that deduction.
However, if he were to sell the property instead after 12 months for the same amount ($1 million), that is when it can get a little complicated.
As Peter has held the property for at least a year, capital gains tax only has to be paid on half of the capital gain. Selling it for the same amount that it was purchased for may have implied that no capital gain was made – sadly, that’s not how tax law works.
Since Peter has also claimed $30,000 in building write off and depreciation which was made back as a capital gain, this means that he has actually made a capital gain of $30,000. From this, Peter would only have to pay tax on half of the capital gain ($15,000), which is then added to his taxable income, incurring a 47% tax on that gain.
This means that Peter will pay $7,050 in extra tax. With his previous year’s tax refund of $14,100 he will have in effect bought and sold an asset for the same amount but received twice the amount of tax refund as the tax he paid.
In this example, taxation is just one consideration that would need to be taken into account. The money spent on stamp duty and agent fees would also need to be factored into the equation.
While overall this example may not have been proven to be a feasible and worthwhile project, it is designed to demonstrate that depreciation and building write off for rental properties can provide a real tax advantage (without having to spend two dollars to save a dollar in tax).
