Property deduction changes - All you need to know
In the 2019 Budget changes to property deductions were announced. In typical budget fashion, the announcement was light on detail and couched around the phrase “integrity improvement”. The changes are focussed on holding costs for vacant land.
After being referred to the Senate Committee and after some last-minute changes, the bill has now passed both houses effective 22 October 2019.
Why all the fuss?
It all started would you believe it in the 1980’s. A Perth pioneer Ms Steele purchased some land near Perth airport for $1 million. The land had stables, horse paddocks, feed rooms, and two houses amongst other things. Ms Steele had grand plans for a motel and residential development (the notion of which would have been quite outlandish in 1980’s Perth). Ms Steele can be described as a pioneer because if you were to look at the area now, it has become exactly what she envisioned.
Despite significant efforts to seek approvals and appoint architects, Ms Steele didn’t proceed with the project and had a falling out with her partner, which then led to the land being sold.
In the intervening period Ms Steele claimed all the interest costs associated with the purchase of the land with the intention of building a motel and some residential development, despite only ever earning a modest amount of agistment income on what was rural land.
The ATO denied the deduction and the case went all the way to the High Court.
It was ultimately determined by the High Court that interest deductions are never capital in Australia, so long as intention can be demonstrated as far as “earning income”, even if this income was at some time in the future, the interest was deductible.
What was important in this case was the evidence Ms Steele could provide to support her intention.
Why the change?
The memorandum to the bill highlights the difficulties the ATO has in determining what a taxpayer’s intentions may be. According to the memorandum there is a perception that some taxpayers are claiming deductions for costs on vacant land that is “not genuinely held for the purpose of gaining or producing assessable income”.
For the avoidance of doubt, legislative change is proposed to clarify when expenses on vacant land can be claimed.
The good news is the bill is actually very short, but this isn’t to say everything is black and white.
The not so good news is the devil is always in the detail, and the current memorandum whilst amended to address a few of the more common situations, is still likely to increase costs for certain entities in situations that wouldn’t appear at odds with the intention of the rules.
Excluded entities
Notably, some entities are excluded:
- Companies (or entities taxed like companies)
- Superannuation funds - NOT Self-Managed Superannuation Funds (SMSF’s)
- Managed Investment Trusts
- Public Unit Trusts
- Unit Trusts or partnerships where the above are unitholders or partners.
What is vacant land?
Vacant land is land where there is no “substantive permanent building, or other substantive permanent structure, that is in use or ready for use”.
Words are open to interpretation and the memorandum provides some useful examples:
- Vacant land on which retaining walls and fencing are erected in preparation for building do not qualify as other substantive permanent structures and the expenses will be denied.
- Land across two titles may have different treatment. Where there is a substantive permanent building, or other substantive permanent structure on one title and the other title is vacant land, expenses can be claimed on the title with the structure.
- Land with dual purpose may require apportionment. Where a business is being conducted on part of land and the remainder is vacant, expenses can be claimed for the portion related to the business. If there was an intention to use the unused portion to, for example, build a rental property in the future, these rules would apply until a substantive permanent building, or other substantive permanent structure exists on the unused portion.
These examples are helpful to understand the intention of the legislators, however whether it provides enough clarity on the most common scenarios that would be denied deductions, despite there being no apparent mischief, remains to be seen.
What about residential premises?
By and large, if you purchase land with an existing property, you can claim the expenses as a deduction, so long as the property can be rented, and you are actively seeking a tenant or earning rent.
If you buy a dilapidated house which is not fit for habitation, this may be considered ‘vacant land’ and captured by these provisions.
If you purchase land and then build on it, you cannot claim expenses related to it until a certificate of occupancy has been issued and you are actively seeking a tenant or earning rent.
Thankfully, and subject to time restrictions, in the case where an existing house/premises becomes unfit for habitation after a period of having been habitable (eg. the recent Mascot Towers situation), a late amendment to the bill ensures that the restrictions on deductions will not apply if “an exceptional circumstance outside of the reasonable control of the entity” were to occur at a point after that time.
What about those in business?
Those who conduct a “business” are excluded from these rules. Without going into too much detail, business in this context means:
- Business of property development; or
- Business of primary production.
A special rule to largely assist primary producers has been included, to capture certain scenario’s where the land is used or held available to be used by certain related parties. One of the late changes was to broaden this further to cover situations where the use and management of large amounts of vacant land are held by entities that don’t carry on the primary production business. Whether these rules go far enough to cover common arrangements, for example between different generations in a farming family, remains to be seen.
The notion of business is also important to understand. Business is not specifically defined so we defer to what the established case law states we should consider. Some of the factors include:
- Extent and volume of transactions
- Degree of repetition of transactions
- Carried on in a business-like manner
- Amount of capital employed
- Intention to generate a profit
What about the situation where vacant land is being used in carrying on a business?
Fortunately, the final late change addresses the situation where land is being made available for business use by someone other than the land holder. This could include the lease of land as car park or storage for example.
The changes will ensure deductions are not denied where:
- The land is leased to another entity on an arm’s length basis
- The land is used or available for use in carrying on a business
- The land doesn’t contain residential premises nor are residential premises being constructed on the land.
Are the expenses completely lost?
The amendments deny deductions but do not preclude them from being included as part of the cost of the asset (cost base) for Capital Gains Tax (CGT) purposes when sold in future.
When will the changes commence?
Consistent with the Budget announcement, the new law applies from 1 July 2019, regardless of when the land was acquired. There is no “grandfathering” of existing arrangements.
Are these changes final?
Whilst there was some back and forth with the bill having been referred to the Economic Legislation Committee and then amendments proposed, the bill has now passed both houses and awaits Royal Assent.
Final comments
It appears trusts and SMSF’s are in the firing line, along with individuals. From 1 July 2019 those who are in structures or have circumstances that do not fit the new conditions, will have their deductions denied. The ATO believe these taxpayers are using the current rules to claim upfront deductions for land that is “not genuinely held for the purpose of gaining or producing assessable income”. Working with numerous clients in this space, we are comfortable that this is not the case in many situations.
The company exclusion is an important one and may lead to different structuring choices in the future.
The specific targeting of land is another interesting policy statement. No such denial applies to those who borrow to invest in company shares in the expectation of dividends in the future.
Where to from here?
Please contact us to discuss how we can help you address your unique situation.