Ring-fencing residential rental property losses
Tax Alert - July 2019
By Robyn Walker and Blake Hawes
With the Taxation (Annual Rates for 2019-20, GST Offshore Supplier Registration, and Remedial Matters) Act 2019 receiving Royal Assent at the end of June, the legislative changes to limit the offsetting of rental property losses are now in effect.
As we mentioned in our previous article on this issue (which covers the topic in more detail), the new rules have an intended application date of the start of the 2019-20 income year. For people with a standard 31 March balance date, the rules apply retrospectively from 1 April 2019.
As we are currently in the first income tax year that will be affected by these rules, there are a few issues that you should be thinking about now before they potentially catch you off-guard come year end.
Property by Property or Portfolio Income?
The legislation requires taxpayers to determine whether they hold their property on a portfolio basis or a property-by-property basis. If a taxpayer doesn’t make an election the default position is that the portfolio basis would apply.
For existing residential rental property owners the election must be made in their income tax return for the 2019/20 income tax year (i.e. the first income tax return that is affected by the new rules).
The key difference between the two methods is that:
- Where a taxpayer elects a property-by-property basis, the expenses of one property cannot be offset against income from other properties. However, if the sale of land becomes taxable due to the land being sold within a certain time-frame (i.e. under the bright line test) the ring-fenced losses for that property can be released and offset against other taxable income of the owner.
- Where a taxpayer elects the portfolio basis, the expenses of one property can be offset against income from other properties, however there are restrictions on the ability to release ring-fenced losses on the taxable sale of a property.
Taxable on sale?
The ring-fencing rules have several exclusions and caveats that may benefit you. The most likely to be utilised is the exclusion for land that would be taxable on sale.
If land will be taxable on sale (meaning it can’t be taxed contingent on selling within the five year bright-line period for example) the ring-fencing rules will not apply to that particular property. However, if the reason that property will be taxable on sale is for any reason other than the fact you are dealing in land, a notification to the Commissioner must be made.
Taxpayers must notify the Commissioner that the property is held on revenue account (i.e. always taxable on sale) within specified time periods, depending on when the property was purchased and/or when the property became revenue account property.
For land that was held at 1 April 2019 (i.e. most taxpayers with existing rental properties) this election must be made by the date for filing the 2019/20 income tax return, which is 7 July 2020 for those without tax agents or 31 March 2021 for those with a tax agent.
Have you thought of…?
- While the new rules refer to the ‘ring-fencing’ of rental property losses, the rules actually operate to stop a loss being created. The legislation limits a taxpayer’s deductions in an income tax year to the extent of the taxable income that arises from a residential rental property owned by the taxpayer. Any additional expenses that exceed the taxable income (the amount that would normally be the loss component) are carried forward as ‘quarantined expenses’ to the next income tax year where they can be applied as deductions to that year’s residential rental property income. If you think you’ve heard of the term ‘quarantined expenses’, before you’d be correct, the same ideology is applied in the ‘mixed use assets rules’ which is why mixed use assets are exempt from these rules.
- While the rules do technically operate to prevent losses occurring, a specific provision within the new rules applies to treat carried-forward quarantined expenses as losses for the purposes of the tax continuity provisions. As such, if your residential rental property is in a company and some expenditure has been quarantined we suggest considering these rules before any shares in the company are sold.
- When multiple properties are held by multiple companies within a wholly-owned group and the properties are held on a ‘portfolio basis’, the residential rental property expenses of one company can be offset and treated as a deduction for another company within the same group, to the extent the second company has also derived residential rental property income. The rules can become tricky if you own properties in more than one way – eg, your own name, via companies, or other entity types. If you are in this position and are thinking about restructuring to take advantage of this concession, you should consider the impact of any time based land sales provisions (such as the bright-line test) before an interest in a section of residential land is transferred to a new owner, such as a company. The bright-line test can apply to tax a transfer of land under a restructure even if there is no true change in ownership.
- Where an entity is interposed between a taxpayer and a residential rental property (for example using a company to hold the property) and the taxpayer has borrowed money to acquire the interest in that entity, that taxpayer’s deduction for interest costs will be limited to the residential rental property income of that entity. We note that this rule only applies to ‘residential land-rich entities’.
- The provisional tax rules may now apply to certain taxpayers who previously used rental property losses to reduce their income tax liability. If your residual income tax liability without rental property losses could be higher than $2,500, you should consider your provisional tax obligations, and how to manage these tax payments, going forward.
As the rules are now in place we recommend consulting your Deloitte tax advisor to ensure you understand all the tax implications to owning a rental property before it’s possibly too late.