Politically, one party has made restricting negative gearing on residential property part of its key platform – but new property, shares and other investments are not in the firing line. A fair question that comes out of this however, is whether it really should be a policy issue for the parliament of the day, or is it really an issue for the ATO to take a stronger approach under current legislation?
The excellent analysis by Dale Boccabella and Stephen Lawrence in their article at 2016 WTB 26  notes the precedent that we are stuck with on apportionment of interest. I agree with their view that the Courts could have arrived at a different conclusion, however without the ATO willing to take this on and/or a case decided in the alterative, this is unlikely to change. As Dale and Stephen note, the issue of apportionment between revenue and capital purposes would be complex and I feel the ATO just doesn't want to take it on. It is focusing its attention on private use and market rent issues.
Politics, policy and a better approach?
Placing the political focus and policy on residential property that is not "new" is indicative of the problems we have in the Australian tax landscape. For such a small country, Australia leads the world in levels of political policy "fixes", complex taxes and "also taxes" such as Medicare, private health insurance levies and a startling array of State taxes and charges that underpin the Commonwealth minefield. Although this keeps me and other advisors in a healthy living, it once again eats into some fundamental principles of tax law. I would suggest that Australia's tax minefield is often the result of political "knee jerk" reactions that are unnecessary.
Doing so after a period of sustained growth in values, exacerbating the perceived mischief, where a decline in values is a real possibility, also seems ill thought out.
There is surprisingly little discussion of what impact the generous capital allowances for buildings have on the perceived mischief and why they remain. There is also no mention of the revenue / capital question on the sale side of the equation.
It is clearly a political policy issue for the government of the day to determine whether the generous capital allowances for buildings continue in all property classes. I will however go out on a limb here and suggest that whether that remains or not, the fundamentals of tax law should not be tinkered with and the ATO can, and perhaps should, address the issue more rigorously.
If we were to accept the suggestion detailed below that geared rental properties may properly be on revenue account in circumstances where the objective intention to sell at a profit exists, how might the ATO address this, given that it may be as equally complex and difficult as apportioning interest?
While it is certainly not for me to tell the Commissioner "how to suck eggs", in the context of the recent favour of setting "Safe Harbour" positions and "circumstances less likely to lead to audit" the following (summarised) position would not in my view be unreasonable:
The ATO is reviewing the treatment of rental properties held where year-on-year a shortfall of income over interest is incurred through the period held and later sale occurs the result of which is claimed as a discount capital gain:
- You will be considered less likely or at low risk of review if you choose not claim more interest than rent received and you later treat the gain on sale as a discount capital gain, which unclaimed interest will reduce.
- If you year-on-year claim more interest than rent received, then you will be considered to have circumstances more likely to lead to an audit or review when you sell, with a focus on whether the sale will be on revenue account or ordinary income without any discount.
A strong position perhaps, but these would only be guidelines and people could take their own advice and position/s. You would however need to be careful on both record-keeping and noting your intention. Any evidence that you always intended to "sell for a profit" would be a problem. But who did not buy a rental property to later sell at a profit over the past decades?
It's a question for another day as to what might happen in a falling market.
Why is this an issue and what is the mischief?
A core principle, where you incur operating costs in order to derive income such as rent, is that you may claim and offset those costs against the income in your tax return. Those costs may include interest on loans to acquire the underlying property, and to the extent that interest exceeds rental received, you are considered "negative geared". But this is a real cost, so it's fair to get a tax deduction, right? To change this on one class of assets only upends the integrity of the tax system for political purposes.
On top of this however, you will likely get a depreciation tax deduction for furniture, fittings and most importantly building costs, which were included in your purchase price and you are not out of pocket for. This supercharges your tax loss and creates tax relief and/or refunds that substantially alleviate any net cash shortfall. In fact, it is possible to have a breakeven or cash surplus while still showing a loss for tax purposes – and the benefit is at full tax rates and offset.
Some see this as overly generous and although any claimed building depreciation is added back and increases your capital gain when you sell, under law and accepted practice, this gain is discounted by 50% and there is a clear overall tax benefit.
The Revenue v Capital issue
Similar to Dale and Stephen, I have for some time been of the view that interest on loans to fund a property acquisition should be apportioned between the purpose of income and the purpose of making a capital gain - the part you don't claim just goes to the cost base for capital gains purposes. Buts it's perhaps all too difficult.
At a November 2014 Tax Institute event, I put the question of negative gearing to an eminent and highly experienced and respected tax professional who responded verbally to the following effect: "If a property is acquired to rent, and year-on-year that property makes a shortfall, and the only way that shortfall might be recovered is by sale at a profit, then arguably that sale is on revenue account".
Simple, considered and someone whose views ought not be ignored. Anyone who considers that property that is leased cannot be on revenue account or even trading stock need only refer to August v FCT  FCAFC 85 and R & D Holdings Pty Ltd v FCT  FCA 981.
It is however a question of intention – at the time of purchase or later – to sell for a profit. While it is acknowledged that not everyone would do so, who could argue that many buy a rental property without the intention to sell later for a profit? It is a question of degree, but an issue the ATO could pursue more vigorously. Large property funds may remain insulated from this on their MIT election. What about shares and other growth investments? A consistent approach on core principles could be applied.
Where to from here?
The ATO has been making inroads with some success on excessive deduction claims in respect of properties not fully leased – although "available" – such as holiday houses and similar used by owners. Perhaps the next step is targeting more closely regular property turnover and/or short ownership, where tax deductions have been claimed. Some genuinely do buy to hold forever or until a surplus is achieved and would have a strong position, but the risk for others is there.
Whatever the political outcome, it's fair to expect that negative gearing will remain on the agenda for property owners. Personally, I would like to see the integrity of the tax system preserved and the perceived mischief or anomaly dealt with in a political sense only via contraction of existing concessions such as capital allowances. That seems to make more sense, but we will see.
This article was first published by Thomson Reuters in Weekly Tax Bulletin.