CAUTION!!! Before acting on any of this info ALWAYS seek the advice of a qualified tax professional. This info, if I have it correct at the time of writing, will quickly become dated anyway.

Be sure to check out the ATO web site at www.ato.gov.au and drop in to an ATO office to pick up the booklets "Rental Properties", "Guide to Depreciation" and "Guide to Capital Gains Tax" (click to download the booklets in .pdf format), or dial 1300 720 092 for the cost of a local call. I have found the ATO tax law database linked from their site to be especially useful in looking up various little sections and deductions that I have read about in real estate books, the majority of it still works but a few of the more dubious deductions have been withdrawn.

Real estate is one of the most tax effective investments, but you should never invest just for tax breaks.

A well thought out investment plan can be made even better with an efficient optimisation of tax deductions, but it is a rare thing to find a good investment plan put together just by knowledge of a few tax minimisation methods. This goes for all forms of investment. A lot of highly paid but financially naïve people have been duped by tax minimisation schemes. They fall down not because there is something wrong with paying less tax, but because the investment behind the scheme was no good. It is always better to share a profit with the tax man, rather than keep a loss all to yourself.

While you can always find some unethical accountant willing to manipulate your figures, lie under oath and exploit some loophole to ensure your long dead cat continues to receive a full military pension, this is not how you need to act in order to get massive benefits from the tax system.

Ethical tax minimisation allows you to make a range of sensible deductions, so that part of your investment is paid for by the tenant and part is paid for out of your tax liabilities. When the Labour government in July 1985 disallowed the immediate tax benefits of negative gearing, requiring that interest costs be rolled up into the purchase cost of the property, disaster followed. What resulted was a heavy downturn in investment in the new building market, a shortage of housing being built to service the high demand in rental properties resulted, rents escalated which hit the poorer classes heavily and unemployment among builders and other workers in the whole sector threatened the whole economy.

The results were so dire that in September 1987 a complete U-turn was made and benefits restored, not only from that day but retrospectively as well. Maybe tax efficiency doesn't enslave the working class and crush the proletariat after all, eh comrades? (To be fair, interest rates in the high teens may have had more to do with the collapse of the market than tax considerations, however the tax changes had the unfortunate effect of reducing cashflow in return for a drop in capital gains tax, making real estate investment far less viable on top of the extraordinary interest rates).

The most important tax minimisation method used is negative gearing. Although seen as being in the realm of greedy and rash speculators, negative gearing when used appropriately is a great wealth builder. Negative gearing means making an apparent loss on cashflow in an asset. The income from rent is insufficient to cover interest payments and other deductions, and so at the end of the year you report a tax loss on your investment. Why does this help? Well it merely means you are continuing to put money into your investment to pay off the house (a kind of forced savings), you pay no tax on your rental income at all and you get to deduct these losses from your regular salary income, maybe even pushing you into a lower tax bracket. The money you are losing is not being wasted, it is paying off a mortgage, and instead of paying a rather large chunk of your money to the tax man all of that money also remains in paying off your asset. Care must be used however, to ensure that you do not over-extend yourself. As long as you can afford the payments this is nothing more than a regular fixed contribution to your savings that you are making.

Of course you could positively gear (expenses are less than income, you make a profit each week), there is nothing wrong with making an immediate and ongoing profit on an investment, but you will pay tax on your income, your tax from your salary will not benefit you in any way and with the $50000 you put in to that first house so your investment is positively geared, you could have bought four or five properties, and enjoy the capital gains on those. Neutral gearing (expenses = income) is also very difficult to make work, amounts paid on your principal are not tax deductible, so you will have to pay tax anyway, your house being paid off is not a zero income situation. It is in fact impossible to set up a tax-free neutrally geared investment unless the loan is interest-only, in which case you may as well just negatively gear, even if only by a very small amount.

So what can you claim as expenses? Council rates, insurance, legitimate fees for property management, accountancy or legal fees, loan interest and sundry business expenses like stationary, bank charges and travel (for inspections).

Depreciation is another major tax deduction, and this works well if you have bought a new house. You can claim the cost of depreciation of furniture, fixings and fittings and even the whole house. For a newer home depreciation can be quite a significant deduction over the years, so if you buy a new home, worth perhaps 60% or more of the original purchase price, over a number years you can deduct the full amount from your profit and loss statement. With these deductions you do actually enjoy a cashflow improvement, your tax liability is much less, even though the building is still sitting there and you haven't actually had to pay thousands of dollars in repairs or really do anything at all.

You won't find anything about depreciation of the building in the ATO Guide to Depreciation because it isn't called depreciation. You can claim a 2.5-4% per annum reduction of the worth of the building as a "capital allowance" (see Section 43, Income Tax Assessment Act 1997), depending on when the building was built.

On 19 July 1985 new tax laws came into effect allowing depreciation on a building to be claimed for the first time. From this date on a 4% deduction could be made for 25 years, however on 16 September 1987 the law was revised and now you are entitled to claim 2.5% depreciation over 40 years. If construction on a property commenced before 19 July 1985 you are ineligible to claim any deduction for depreciation. Buildings commenced between 19 July 1985 and 16 September 1987 can be depreciated at the 4% rate for 25 years from the date of completion, you will have to discount the period between 1985 and the date you actually bought the property of course, so here in 2001 you have only 16 years of depreciation left. Any house built after 16 September 1987 is depreciable at the rate of 2.5% for 40 years from the date of completion.

You will need to find out the original cost of the building from the builder, if the builder can not be found a reliable estimate of the cost of the building must be made (and you need to back up your figures to the ATO if they ask). If the builder of the house can be located but refuses to tell you how much the cost of that particular building was, you can quote Section 43 at him and what usually happens is he will usually scurry off to his accountant and check this out and be told that indeed he must tell the investor what the original price was. If the house is not brand new, you must index your building value by deducting the appropriate amount for the age of the building.

You cannot claim acquisition costs for a property in your income profit and loss statement, including the purchase cost of the property, finder's fees, conveyancing costs and advertising expenses. These expenses are included in the cost base of the property for capital gains tax purposes.

Borrowing expenses such establishment fees, valuation fees, title search fees and costs for preparing and filing mortgage documents, are spread over the first 5 years of the loan, or the term of the loan, whichever is lesser, unless the total cost of these is under $100 in which case they are fully deductible in the first year.

Repairs to an investment property are deductible if they relate to the repair of a damaged or worn item such as part of a fence, replacement guttering and replastering following water damage. If repairs are of a more general upgrade nature, and is likely to be seen as a home improvement such as replacing an entire old wooden picket fence with a new asbestos type, the expenditure is treated as a capital upgrade and included in capital gains calculations when you dispose of the property. Permanent improvements to the structure are regarded as capital improvements, anything from reticulation to pool pumps that are bolted to the floor, buried or otherwise considered to be installed in their permanent position is subjected to the 4/2.5% capital allowance deduction.

Formerly under Section 67A of the tax code, you could pay 10% of the total rental income to your spouse, a friend or anyone else of your choice, as a management fee for maintaining the books of your rental property. This section was terminated in the 1997-98 taxation year. The whole section was scrapped and has no equivalent today. I am putting this here because you still find reference to it in some of the real estate books you will probably take out from the library.

Travel expenses can be claimed also, if you have an interstate property and you fly to inspect the site, stay overnight and return home the next day, normally 100% of your flight and accommodation costs can be claimed as a deduction. For longer stays you may need to apportion the expenses between private holiday time and work time, unless good evidence can be provided as to why the inspection took more than one day. Other travel expenses such as travel to an investment holiday home that is rented out part of the year or time-shared must be defined as investment related or private. You are not entitled to claim the costs of flying to your investment property by the ocean if you are merely going on vacation.

By optimising your taxation a properly set up real estate investment will be paid for entirely out of other people's pockets, mostly by the tenant and a significant amount by the taxman. When all is said and done and your accountant has done his work, you can be a real estate investor without having to sacrifice a cent of your own money. Only a very small proportion of Australians invest in the correct type of real estate, understand the depreciating nature of a building and optimise their tax.

While the interest on an investment property can be claimed as an expense, the interest on your own home can not. It will always be a more tax effective strategy to try to get an interest-only investment loan or negotiate very long terms on your investment loan. Any cash generated by your investments should be put into paying off your own mortgage (see mortgages/mortgage or investing?). The money paid into your own home is increasing your total equity, which can be borrowed against to buy another property. For the reasons given on the mortgage page, (money savings are not taxed as income), saving money on the interest on your own home is a very good idea. For more information see the mortgages section and the finance section of the real estate section.

You must keep proper records of both income and expenses for a period of at least five years from the date you dispose of them. The ATO may ask for copies of these records, you do not send them in with a tax return.

Before you get too excited about depreciation as a tax deduction, you might want to consider one thing that is rarely mentioned by real estate promoters who tell you all about these wonderful tax breaks. The tax office grants you the right to claim depreciation because things depreciate. This sounds all a bit trite really, but think about it. The ATO doesn't grant you this tax break because they feel like being nice to real estate investors, they grant this because it would be very unfair not to, since things really do physically deteriorate. You will need to replace the carpets from time to time, if you don't upgrade the kitchen your property will become less attractive to renters after a while. You need to replace the gutters and fix the fences, paint the walls and put in new curtains from time to time. This small detail is often forgotten when people are shown the sums by a developer flogging investment properties. People tend to get a bit carried away by the concept of free subsidies from the tax man, but they are only there to allow you to pay for necessary replacement of plant, it is not free money from the tax office.

I have written more articles that have relevance to real estate investors in the Tax FAQ, so read that next.