What was the announcement?
The Budget (on 9 May 2017) stated that plant and equipment depreciation deductions will be limited from 1 July 2017 to “outlays actually incurred by investors in residential real estate properties”. Also, from 1 July 2017, deductions for travel expenses will be disallowed where they relate to “inspecting, maintaining or collecting rent for a residential rental property”.
Who do the new depreciation rules apply to?
The budget paper states that the new rules will apply to “investors” or “investment properties”. It is not clear whether these terms are intended to limit the deduction to a certain type of entity (e.g. whether it will apply only to individuals). It is also not clear whether these terms are intended to limit the deduction to certain types of investments (e.g. passive rental holdings versus taxpayers carrying on a business). We understand the legislation will clearly identify the scope of the provisions once released.
What is plant and equipment?
While the budget paper states it will limit depreciation deductions on plant and equipment, this term is not currently defined for income tax purposes. It is our understanding that the budget paper has used this term consistently with the ATO’s “Guide for rental property owners - Rental properties 2016”, which at page 31 provides a definition of “plant”. In this context, the term refers to all depreciating assets subject to depreciation claims other than the building capital allowance write-offs. Accordingly, we expect the new measures to have broad application to depreciable assets.
What about capital works on building structures?
A deduction for capital works of 2.5% or 4% (depending on the type of capital works undertaken) is available for construction expenditure (which, for example, would include construction expenditure of the building). The budget paper does not refer to capital works deductions being covered by the measure. We believe that this is intentional and consequently, we believe that deductions for capital works will continue to be available.
Can you separately purchase plant and equipment for an existing property and obtain a depreciation deduction?
The budget paper stated that depreciation deductions will be limited to “outlays actually incurred by investors”. While initially, this may indicate that deductions could be available if plant and equipment are separated from the purchase of the property (e.g. under a separate contract), we do not believe that the provisions will allow for this. We note that the budget paper states that deductions will not be available for “subsequent owners of a property”, which we believe would limit the deduction even if the items were separated into two contracts.
Therefore, we believe that depreciation deductions will be denied even if you separately purchase plant and equipment for an existing property.
What is a residential investment property?
The budget paper refers to the new rules applying to “residential investment properties” or “investors in residential real estate properties”. Neither term is currently defined for income tax purposes.
It is unclear as to the scope of this term, which includes a number of concepts. The first concept is “investment” or “investor” which may have the effect of limiting the application to certain types of property holdings (see 'Who do the new depreciation rules apply to?' above).
The second concept is “residential”. Generally speaking, we would expect the term “residential” to cover a property that is capable of being used primarily for residential purposes. For example, we believe that this would more than likely include a house, a townhouse or an apartment. However, it is not clear whether this measure would include other types of properties such as commercial properties being used for residential purposes, hotels, hostels or retirement villages.
We would expect the final measures to provide a definition of “residential investment property” that makes it clear as to the scope of the provisions.
What will be the treatment of the plant and equipment if you cannot depreciate the items?
The budget paper stated that plant and equipment that is not able to be depreciated will form part of the cost base of the CGT asset for those subsequent investors. However, this in itself creates some uncertainty on its treatment.
Firstly, the budget paper is unclear as to whether the assets will qualify for a deduction for capital works (i.e. the 2.5% or 4% write-off). In our view, we do not believe that this would be the case, given that the current capital works provisions already deny a deduction for items of “plant”.
It is unclear whether a loss on the disposal of such a depreciating asset will be on revenue or capital account. However, given that the budget paper refers to adding the amounts to a CGT cost base, we would expect that the provisions would make it clear that the disposal would only be on capital account.
It is also is unclear whether the “cost base” is to be recorded for each item of plant or equipment, or whether it is added to the underlying property. This is important, especially to the extent that plant or equipment is disposed of or replaced during the investment period. At this stage, we are not clear as to which of these two options will be chosen.
Finally, the CGT provisions currently exclude capital losses or capital gains that are derived on depreciable assets. We would expect that the final measures would make an exception to this rule for these types of depreciable assets.
Are there transitional provisions for the depreciation rules?
It is proposed that properties purchased before 9 May 2017 will not be subject to the new rules. Contracts of sale signed before 7.30pm (AEST) on budget night will also not be subject to the new rules, even if settlement is yet to occur. Consequently, existing holders of a residential investment property will be able to continue to claim depreciation deductions for the life of the plant and equipment until the investor no longer owns the asset or the asset reaches the end of its effective life.
All other residential investment properties purchased, other than those outlined above, will be subject to the new rules.
What happens if you buy a property off the plan after 9 May 2017?
The budget measures propose to limit depreciation deductions to “outlays actually incurred” where the purchaser is a “subsequent owner”. Therefore, if you purchase off the plan, we expect that plant and equipment that is included in the purchase will be available for depreciation deductions (irrespective of whether one or two contracts are used). This is because the purchaser will not be a subsequent owner in this case.
We also believe that this will be the case irrespective of whether the plant and equipment is second hand, or whether the developer first purchases the items and then on-sells those items to the purchaser of the premises.
Accordingly, we do not believe that off the plan purchases will be subject to the proposed new rules.
What if the residential property is substantially renovated just before it is purchased?
Depreciation deductions will not be available to “subsequent owners of a property”. Where a purchaser buys a renovated property (where all the plant and equipment items are brand new), there would be a question as to whether the plant and equipment items would be subject to the limitation.
We note that for GST purposes, a property can be treated as new residential premises when it has been “substantially” renovated, where all or substantially all of the building has been removed or replaced. We believe that this type of definition would also be appropriate in the context of this new measure if a person acquires a property that has been substantially renovated and includes new plant and equipment. However, based on the current budget proposal, as the new owner would be regarded as a “subsequent owner” no depreciation claims would be available.
To that end, we believe it would be appropriate if plant and equipment is not subject to the limitation rule where the previous owner has not depreciated the plant or equipment items previously and they are (essentially) brand new. However, as currently proposed in the budget paper, the measures may not exclude such items.
What travel expenditure is covered by the budget proposal?
From 1 July 2017, the Government will disallow deductions for travel expenses related to inspecting, maintaining or collecting rent for a residential rental property. This measure is aimed at taxpayers that may have been claiming travel deductions where a portion of the costs would ordinarily have been private travel (e.g. travel to inspect a holiday home in Queensland while staying for a few days).
Importantly, the proposed measure is not intended to prevent investors from engaging third parties such as real estate agents for property management services. These expenses will remain deductible.
At this stage, the budget paper does not provide a definition of a third party (and whether this may include related parties). For example, where a property is owned by a trust, it is not clear whether a payment to a beneficiary to inspect the property would be a payment to a third party. We anticipate that the final legislation would deny deductions for payments to “associates” of the entity.