This article was first published in Australian Property Investor Magazine and is copyright and reproduced with their permission.

There are some golden rules that Australians with overseas rental properties need to follow if they don't want a visit from the taxman.

As Glenn Wheatley now knows all too well, Australians are taxable in Australia on all their worldwide income. This even applies if the country of origin has also taxed the income, though Australia will give you a credit for the tax you pay to another country.

With the Australian Tax Office (ATO) proudly beating its chest about its success in spending $300 million on Operation Wickenby which discovered that Wheatley hadn't paid $318,092 in tax, readers may be suitably concerned as to whether they've done the right thing with their overseas rental properties.

Buying a property overseas
Your net rent income from the overseas property is determined according to Australian tax law and included as foreign income in your Australian tax return, with a credit for any foreign tax paid. This foreign tax credit can only be used to meet the Australian tax due on foreign income of the same class.

The Australian tax rate applicable to foreign income is your average tax rate including Medicare levy but not taking into account any rebates or tax offsets you receive. So to calculate your average tax rate, take the amount of tax you should pay on your total taxable income for that year plus the Medicare levy but before deducting offsets and rebates. Divide this amount by your total taxable income to get your average tax rate. Multiply your foreign income by this percentage. If the result is less than your foreign tax credit you can carry the unused portion over to future years.

There is an exception to this rule, in that the interest and borrowing costs that relate to an overseas property can be offset against Australian income if the income from the property, after deducting all other expenses, isn't enough to cover the interest and borrowing costs.

In ATO Interpretive Decision 2002/764 it states that, from July 1, 2001 Section 160AFD allows the interest, borrowing costs etc. on an overseas rental property to be offset against Australian income to the extent that it exceeds the overseas rent received. This is rental income after the deduction of other expenses (such as rates, insurance and repairs), providing they don't exceed the total amount of rent received.

If the rates, insurance and repairs exceed the rent received the balance is carried forward to be offset against future foreign income and the interest is fully deductible against Australian income.

If the rates, insurance, repairs etc. are less than the rent received then the interest is offset against the rent until the net result is zero, then the balance of the interest and borrowing expenses are offset against Australian income.

It doesn't matter which country the money is borrowed in but note, if you're making interest payments to an overseas lender you're required to deduct 10 per cent withholding tax and remit it to the ATO.

Stop the press
The Tax Laws Amendment (2007 Measures No. 4) Bill has just been introduced to Parliament. It proposes that the quarantining provisions discussed here will be abolished in the first financial year following the Bill receiving Royal Assent. So if the Bill is passed, the quarantining provisions probably won't operate in the 2008 and following financial years. This means all foreign losses, not just interest, will be able to be offset against Australian income and foreign tax credits can be used to pay tax on Australian income.

Residents of Australia will be subject to capital gains tax (CGT) on the sale of any overseas properties acquired after September 19, 1985. The 50 per cent discount is available if the asset is held for more than 12 months.

For the purposes of the tax return this amount is recorded as capital gains, not foreign income.

A capital loss isn't quarantined like foreign income is. A foreign capital loss can only be offset against capital gains but it can be Australian or foreign. Capital losses have special offset rules (refer ATO Tax Ruling IT2562). In short, this allows foreign capital losses to be offset against Australian capital gains first, thus maximising any other foreign capital gain and so maximising the opportunity to use the foreign tax credits from the foreign capital gain.

If you're entitled to a credit for foreign tax on your capital gain, your tax return will need to be lodged manually with a note detailing this, as there's no facility within a normal electronic tax return to record the credit.

Working overseas
If you work overseas for less than two years, you could still be considered a resident of Australia for tax purposes.

Section 23AG exempts employment income earned overseas from Australian taxation, providing the following conditions are met:

1) The employment is for a continuous period of 91 days. Note: continuity isn't broken by absences due to accidents or illness or recreation leave, which is part of the terms of your employment contract. Weekends, public holidays, compassionate leave etc. don't break continuity, nor do business trips for the foreign employer. But continuity is broken by long service leave or leave on reduced or no pay. More detail can be found in Taxation Ruling 96/15 which also addresses the absentee credit system.

2) You're taxed on this income in the foreign country. Note: Australia has different double tax agreements with each country so you'll need to know exactly what applies to your country.

While Section 23AG exempts the income earned overseas, it doesn't exempt from Australian tax your other income such as interest, royalties, dividends, rent etc. if you're still considered to be an Australian resident for tax purposes (that is, you intend to return to Australia within less than two years). This two-year rule isn't hard and fast; it boils down to a question of fact.

If you've earned exempt employment income overseas but you're still a resident for tax purposes in Australia, the exempt income is taken into account to determine which tax bracket is applied to your other Australian income. So it's important that you keep a record of how much you earned overseas and the dates. Note that how much you earned overseas is after allowing for deductions against that income that would have been deductible according to Australian law.

How the main residence exemption works
Section 118-145 of the 1997 Income Tax Assessment Act is the section on the six-year rule. At sub section (4) it gives the following example:

"You live in a house for three years. You're posted overseas for five years and you rent it out during your absence. On your return you move back into it for two years. You're then posted overseas again for four years (again renting it out), at the end of which you sell the house. You haven't treated any other dwelling as your main residence during your absences. You may choose to continue to treat the house as your main residence during both absences because each absence is less than six years. You can make this choice when preparing your income tax return for the income year in which you sold the house."

So you can chose to exempt a property in Australia that you've lived in for up to six years while you're away, if it's rented out. If it isn't rented out (i.e. your adult children live there), you can cover it with your main residence exemption indefinitely.

Becoming an overseas resident for tax purposes
Whether you're a resident for tax purposes has nothing to do with your country of residency. Just being out of Australia for six months could make you a non-resident for tax purposes. Taxation Ruling 98/17 (available from www.ato.gov.au) discusses this matter in detail.

If you set up a home overseas and live there for a couple of years you're definitely a non-resident for tax purposes. If you're travelling overseas (so not setting up a home) you could be gone for more than two years and still be a resident of Australia for tax purposes. Just setting up a home overseas for six months could make you a non-resident for tax purposes.

When a taxpayer becomes a non-resident of Australia Income Tax Assessment Act 1997 Section 104-160 deems a CGT event to have occurred. That is, you're considered to have disposed of all your assets that aren't "Taxable Australian Property" and acquired after September 19, 1985 at their market value. Accordingly, you'll be subject to CGT on any increase in value over their cost base (see last month's API for more details about this).

Section 104-165(2) gives you the option of ignoring the capital gain accrued when you leave the country but this will effectively mean you're taxed on any gain while you're a non-resident. The options offered by Section 104-165(2) are:

a)defer the CGT and pay it when the asset is sold, but the tax will be on the gain over the whole period up to the sale including when you're a non-resident, or

b) defer the CGT on the basis you'll be returning to Australian residency before you sell it, but when you do sell there will be no exemption for the gain made while you were a non-resident.

So the choice is pay the tax when you leave and be free of Australian tax on any gain you make while a non-resident or defer the tax but widen the period of time you're exposed to Australian capital gains tax.

As your home will be "Taxable Australian Property" you won't be deemed to have disposed of your home by Section 104-160 if you decide to keep a home in Australia to return to. If you own a house overseas while a resident of Australia and then become a non-resident of Australia, the overseas house isn't "Taxable Australian Property" so Section 104-160 will deem it to have been disposed of.

Upon leaving Australia you'll have to notify anyone paying dividends that you're no longer a resident for tax purposes. Unless the dividend is fully franked, it will be subject to non-resident withholding tax at the rate of 30 per cent for countries that Australia doesn't have a double tax agreement with and 15 per cent for countries that it does.

Any interest paid to you from Australia will be subject to 10 per cent non-resident's withholding tax.

NB. This information is of a general nature only and does not constitute professional advice. Readers should not act on the basis of any matter on this website without taking professional advice with due regard to their own particular circumstances.