Loss Ring Fencing on Rental Properties
The government will introduce loss ring-fencing on residential rental properties, which is scheduled to become law effective from 1 April 2019. This means it will apply for the 2020 tax year. The tax legislation proposed is complex and politically motivated.
What Changes are proposed?
For years, residential property investors have been able to use losses on rental properties to offset their personal tax. Residential rental properties are often "negatively" geared. This means that the expenditure exceeds the income, resulting in a loss. The government has proposed ring-fencing these losses and preventing investors from using any losses against their personal tax.
How will it work?
At its most basic, any losses will be carried over to the next income year. The losses won't be able to be utilised until the investment makes a profit.
The ring-fencing will apply on a portfolio basis, so if an investor has more than one property, losses on one can be offset against profits on another. Interestingly, there is the option to opt out. Investors can 'elect' to have any losses ring-fenced on a property by property basis. This could be useful for portfolio investors if the ring-fenced losses on a property are likely to exceed any gain when sold. However, no one buys a property with the intention of making a capital loss.
For many investors, it will take some time to pay down a mortgage before the investment becomes profitable. The ring-fenced losses won't be utilised until quite some time in the future. We foresee that there will be upward pressure on rents, to try and get the rental property to at least break even.
What can losses be utilised for?
Future residential income and any income on the sale of residential land e.g. any capital gain caught under the Bright-line test rules. Importantly, losses can't be used to offset income from other investments.
What about Trusts?
Trusts will also have losses on residential properties which are ring-fenced. These losses won't be able to be applied against other income, such as shares or managed funds.
Is my Look Through Company now useless?
Losses will no longer flow through to the shareholders automatically. Losses will be allocated to the shareholders to be used against future profits from residential properties.
Losses will be ring-fenced the same way. However, the shareholder continuity rules will apply when a shareholder reduces their shareholding. This means that the losses can be forfeited, often quite unintentionally.
Where there is more than one company in a group, the losses will be able to be transferred to another company, but only if the companies in the group have identical shareholder(s) i.e. they are wholly owned.
What property is excluded?
a) A taxpayer's main home if they are renting out part of it;
b) Mixed-use assets as there are already specific rules on these;
c) Any property that was bought from the outset with the intention of resale;
d) Certain accommodation provided for employees, and:
e) Property owned by 'widely-held' companies (e.g. 25+ shareholders).
When is it intended to take effect?
The bill needs to work its way through all stages in Parliament and there may be changes to the bill, but it's been signalled to become legislation effective from 1 April 2019.
What's our view?
It's unfair if there is an actual economic loss to deny a tax deduction. It also is unfair to target one sector of the economy and treat it differently from say a commercial rental. The compliance costs and administration will be high.
We believe that there will be less people willing to stick their neck out and buy a rental property. Rents will increase as a result.
Example 1 - Individual
Bert is paid an annual salary of $100,000 with PAYE deducted of $24,580. He owns a residential rental property which makes an annual loss of $10,000.
Loss Ring Fencing will mean Bert can no longer deduct the $10,000 from his personal income so no PAYE refund. He will have to carry $10,000 of expenditure forward to the next tax year where it can be offset against property income in that year and so on.
What if - Bert in year 4 sold the property for a $40,000 profit that is taxable under the bright line rules and accumulated rental losses at that point of $35,000. Bert can allocate the $35,000 of the accumulated rental losses to reduce the taxable gain on the property to $5,000.
What if – Bert in year 6 sold the property for a non-taxable $100,000 gain (ignoring any possible capital gains tax) and accumulated rental losses at that point were $60,000. The $60,000 remains ring fenced for Bert to use against any future residential rental property income he may have.
Example 2- Trust
Ernie is a trustee and one of the beneficiaries of Sesame Trust. Sesame Trust has a residential rental property which makes a loss of $10,000 for the year. Sesame Trust also has other investments to the value of $300,000 which generated income of $30,000 for the year.
The net trustee income of $20,000 has been allocated to Ernie. However, because of loss ring fencing there is taxable income remaining in the trust of $10,000. In effect the loss from the residential rentals will be carried forward to offset future years residential rental income.
Example 3 – Look Through Company (LTC)
Big Bird Ltd is an LTC that owns a residential rental property which makes a loss of $10,000. Under the new proposed legislation, the $10,000 loss will be ring fenced for the owners and allocated to future residential rental income from the LTC.
There are many more complicated scenarios which we shall deal with on a case-by-case basis dependent on the specific facts.