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Getting claims right is more important than ever with the ATO’s increased focus on residential rental properties.
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Common tax traps for residential rental properties
11 April 2024
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As we approach the end of the income year, this is an ideal time to look at the traps that can trip up agents when preparing rental property schedules for clients as part of their income tax returns. Against this backdrop, the ATO continues to focus on taxpayers correctly disclosing all their rental income and claiming rental deductions. During Tax Time 2023, the ATO explained that the ATO’s review of income tax returns showed nine in 10 rental property owners are getting their returns wrong.
This article reviews the legislative changes affecting residential rental properties (RRP) and the areas where taxpayers are most at risk of making incorrect claims.
Keeping up with legislative change
Improper conduct and incorrect claims by taxpayers relating to RRP led to a wave of annual legislative changes between 2016 and 2020. These amendments targeted specific concerns with some taxpayers doing the wrong thing yet — as is often the case with contemporary policy development — the changes apply widely to the entire class of taxpayers who own RRP.
Changes from 1 July 2016 — Foreign resident capital gains withholding regime
The FRCGW regime was first announced on 14 May 2013 as part of the federal budget 2013–14 and is contained in Subdivision 14-D of Schedule 1 to the Taxation Administration Act 1953 (TAA). It first applied to acquisitions of certain Australian real property and related interests under contracts executed on or after 1 July 2016.
Initially, the FRCGW regime imposed a non-final obligation on the purchaser of the property to pay 10 per cent of the purchase price to the ATO where the property was acquired from a foreign resident vendor and cost more than $2 million in the case of residential property.
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For FRCGW purposes, all sellers are taken to be foreign resident vendors. However, those who are Australian residents can avoid the obligation by obtaining a clearance certificate from the ATO and providing it to the purchaser before settlement. The amount of the payment can also be reduced by applying for a variation from the ATO. Certain other exclusions also apply.
The law was amended with effect from 1 July 2017 to increase the rate of withholding from 10 per cent to 12.5 per cent and reduce the withholding threshold from $2 million to $750,000.
The government announced as part of the Mid-Year Economic and Fiscal Outlook 2023–24 that it would increase the rate of withholding from 12.5 per cent to 15 per cent and reduce the withholding threshold from $750,000 to $0. The changes will apply to real property disposals with contracts entered into from 1 January 2025.
Changes from 1 July 2017 — Claiming travel expenses and depreciation on certain RRP assets
The ATO identified that some taxpayers were improperly claiming travel costs incurred in inspecting or maintaining a RRP (or collecting rent) without correctly apportioning costs, or were claiming private travel costs. To combat this, section 26-31(1) of the Income Tax Assessment Act 1997 Act (ITAA 1997) denies a deduction for travel expenditure incurred in gaining or producing assessable income from residential premises and ensures such amounts are not recognised in the CGT cost base of the property.
This provision has applied since 1 July 2017 and includes motor vehicle expenses, taxi or hire car costs, airfares, public transport costs, and any meals or accommodation related to the travel. Exceptions to the non-deductible rule are set out in section 26-31 of the ITAA 1997.
A label for claiming travel expenses remains in the ATO’s Rental property schedule to cater for non-residential property or residential property owned by excluded entities.
Changes were also made from 1 July 2017 to address opportunities for successive property investors to ‘refresh’ the value of previously used depreciating assets and claim amounts more than the assets’ actual value by allocating a portion of the purchase price to depreciating assets (i.e. plant and equipment) acquired with the property and claim capital allowance deductions.
Broadly, taxpayers cannot claim depreciation for income years commencing on or after 1 July 2017 on second-hand depreciating assets in a RRP that were acquired at or after 7:30pm on 9 May 2017. Exceptions include where the property is used for carrying on a business, the taxpayer is an excluded entity and where the property was rented out (wholly or partly) in the 2016–17 income year.
Notably, where depreciation is unable to be claimed due to the operation of subsection 40-27(2) of the ITAA 1997, the taxpayer makes a capital loss under CGT event K7. The amount of the capital loss is the proportion of the depreciation of the asset (that is, the difference between the asset’s termination value and its cost) that the taxpayer has not been able to deduct because of section 40-27.
Detailed records of the allocation of both purchase and sale prices between the property (land and dwelling) and the rental assets need to be kept. This enables the correct calculation of the amounts of depreciation that can be claimed and the capital loss under CGT event K7 on the sale of the property (separate from the capital gain or loss from CGT event A1).
Changes from 1 July 2018 — GST at settlement
The impact of the time lag in remitting GST that enabled property developers to engage in ‘phoenix activity’ was succinctly captured in these remarks in a 2018 explanatory memorandum accompanying an amending bill:
Phoenixing to avoid paying GST has grown significantly over the last decade. As of November 2017, the ATO has identified 3,731 individuals [who] have actively engaged in this activity over the last five years. These individuals controlled over 12,000 insolvent entities responsible for $1.8 billion in debt that has been written off. The insolvent entities also claimed $1.2 billion in input tax credits between 2013 and 2017.
These concerns led to the introduction of a payment obligation, similar to that under the FRCGW regime, with effect from 1 July 2018 whereby purchasers are required to pay an amount to the ATO at settlement. Subdivision 14-E of Schedule 1 to the TAA imposes a GST payment obligation on recipients of taxable supplies of real property that are ‘new residential premises’ or new subdivisions of ‘potential residential land’. It also imposes notification requirements on entities making those supplies.
Broadly, the purchaser is required to pay one-eleventh of the price for the supply, or 7 per cent of the price if the margin scheme applies. Suppliers of residential premises or potential residential land must notify the purchaser to advise whether a withholding payment will be required at settlement. Most standard land contracts now include the information required to discharge a supplier’s notification obligations. The supplier is entitled to a credit only where the purchaser has paid the amount to the Commissioner.
Common errors being made on forms submitted by property purchasers and their representatives are often the result of incorrect supplier notifications. Checking that the supplier details are correct will prevent processing delays in the supplier receiving their property credit. The ATO’s prescribed forms should be used for payment and reporting purposes.
Changes from 1 July 2019 — Vacant land changes
Since 1 July 2019, section 26-102 of the ITAA 1997 has denied a deduction for expenses associated with holding vacant land. Again, certain exclusions apply, such as where the property is used for carrying on a business or is held by primary producers and where the taxpayer is an excluded entity. Land is considered ‘vacant’ where there is no substantial and permanent structure in use or available for use on the land.
While vacant land may be considered distinguishable from RRP, section 26-102(4) contains a special rule for determining if land that contains residential premises (within the meaning of the GST Act) is vacant. Residential premises are to be disregarded and the land treated as remaining vacant until the residential premises are:
- Lawfully able to be occupied under the law.
- Leased, hired or licensed or available for lease, hire or licence.
This rule means a taxpayer cannot deduct the costs of holding land containing residential premises until the premises can be legally rented and the taxpayer is actively seeking to derive income from the use of the property as residential premises. It ensures that in the context of a rental property, statements about intention are not sufficient.
Losses and outgoings that are not deductible in an income year because of section 26-102 may be included in the CGT cost base of the property.
Changes from 1 July 2020 — no main residence exemption for foreign residents
Since 1 July 2020, section 118-110 of the ITAA 1997 denies the main residence exemption (MRE) to foreign residents (or since 9 May 2017 where the property was not held before that time).
Insofar as these rules affect a taxpayer who is a foreign resident at the time of the CGT event and owns a dwelling that was used as their main residence and then subsequently rented it, they cannot:
- Continue to treat the dwelling as their main residence after they vacate it (under the six-year absence rule) which would otherwise allow them to continue to treat the dwelling as their main residence for up to six years.
- Reset/uplift the cost base of the dwelling to its market value on the date it was first rented.
This is because these special rules are available only where the MRE is available. Except certain life events, foreign residents are not entitled to the MRE.
Common errors when lodging tax returns
To assist taxpayers, the ATO published the Top 10 tips to help rental property owners avoid common tax mistakes:
- Getting initial repairs and capital improvements right — initial repairs cannot be claimed as a deduction and form part of the CGT cost base. A capital works deduction may be claimable.
- Claiming interest on your loan — only that part of interest incurred on loans that relate to the RRP can be claimed. The interest must be apportioned if some of the loan has been used for personal use.
- Claiming borrowing expenses — Where borrowing expenses are more than $100, the deduction is spread over five years. However, this is not a straight-line claim and the costs must be apportioned in the first year based on the number of days the property was owned (so the claim extends over six income years).
- Claiming purchase costs — costs of buying and selling a RRP, such as stamp duty and conveyancing fees, are not deductible and are used to work out the capital gain or loss.
- Getting construction costs right — certain building costs, including extensions, alterations and structural improvements, can be claimed as capital works deductions at 2.5 per cent of the construction cost (over 40 years) from the date construction was completed.
- Claiming body corporate fees — payments made to body corporate administration funds are fully deductible in full in the income year they are incurred, but funds raised by a body corporate and applied to a special purpose fund to pay for major capital improvements or repairs are of a capital nature and are not immediately deductible. They may be claimable as a capital works deduction.
- Apportioning expenses and income for co-owned properties — rental income and expenses for co-owned RRPs must be declared and claimed according to the legal ownership. Joint tenants have an equal split while tenants in common calculate the split based on the proportion of ownership interests.
- Apportioning deductions for private use of the property — deductions can be claimed only for the periods and to the extent the RRP is being rented or is available for rent. If only part of the property is used to earn rent or it is rented out for only part of the year, the expenses must be apportioned to reflect the area and days it was rented.
- Keeping the right records — taxpayers must be able to provide evidence of their rental income and expenses and how they worked out their capital gain/loss.
- Getting capital gains right when selling — the cost base needs to be correctly worked out. Do not include amounts already claimed as a deduction against rental income earned from the property, such as depreciation and capital works deductions.
The list below is a further non-exhaustive list of tips to address other common errors made when lodging tax returns and claiming rental deductions:
- Ensure the net rental income figure received from the property agent is grossed up — do not double dip on expenses by declaring only the net rental income and claiming the expenses again against this figure.
- Apportion the rental deductions where ‘mates’ rates’ are charged on the rental income.
- Ensure improvements are correctly identified as capital, including where repairs are undertaken that replace the whole or entirety of a depreciating asset.
- Correctly distinguish between the cost of depreciating assets and capital works.
- To claim deductions for holiday rental properties, they must be genuinely available for rent.
- Taxpayers cannot claim deductions for the cost of their own labour when undertaking cleaning, repairs or construction works on their RRP.
- Prepaid interest can be claimed as an immediate deduction provided the eligible service period of the prepayment is no more than 12 months and ends by the end of the income year following the one in which the prepayment was made.
- Negative gearing remains available on RRPs.
- Assets costing less than $300 can be immediately deducted. However, where the asset is part of a set, or is identical or substantially identical to another asset, bought in the same income year and the total cost exceeds $300, the asset must be depreciated.
- Post-28 August 1991, third element holding costs form part of the cost base where the property is not being used for a taxable purpose (e.g. holiday house between rental periods where it is not genuinely available for rent).
- Resetting the cost base of a RRP when the property is rented is not a choice and happens only where the dwelling was used only as the taxpayer’s main residence before it was first used to produce assessable income. It is also not reset each time the property is subsequently rented.
- The six-year absence rule can be used only where the taxpayer ceases to treat the dwelling as their main residence — it is not enough to simply vacate the property for a few days or a few weeks. In this case, only a partial MRE will be available on sale.
- Land tax and similar state-based holding taxes (such as vacancy taxes and the proposed Short Stay Levy in Victoria) are fully deductible.
- With the sharing economy reporting rules and the ATO’s sophisticated data matching protocols — including the Rental bond and the Residential investment property loan data matching programs — it is more difficult than ever to escape the ATO’s radar.
Closing comments
It is easy to trip up when navigating the array of rules that apply to RRPs. The right questions need to be asked of clients, the right documentation must be kept and a deep understanding of the law is required to get it right when declaring rental income, claiming rental deductions and reporting capital gains or losses. The ATO remains focused on these types of claims so, going into tax time, review your checklists and processes. Hopefully, in a year, we will see a pleasing fall in the currently high rate of RRP errors in tax returns.
About the Author
Robyn Jacobson is the Senior Advocate at The Tax Institute.
About The Tax Institute
The Tax Institute is the leading forum for the tax community in Australia. Our reach includes membership of over 10,000 tax professionals from commerce and industry, academia, government and public practice and 40,000 Australian business leaders, government employees and students. We are committed to representing our members, shaping the future of the tax profession and continuous improvement of the tax system for the benefit of all, through the advancement of knowledge, member support and advocacy. Read more at taxinstitute.com.au
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