New depreciation rules for investors in residential property - do they apply to you?

By Michael Hay - September 22, 2017

On 7 September 2017, the government released its Housing Tax Integrity Bill into Parliament to give effect to its Budget announcement regarding investors in residential property (click here to see our initial analysis). In this bulletin we explain the latest developments and identify areas of concern with the Bill as drafted.

Who do the rules apply to?

The Budget Paper stated that the new rules would apply to “investors”, without clearly defining who would be included. The Bill states that the new rules do not apply to companies, super funds other than self-managed funds (SMSF), public unit trusts, managed investment trusts or partnerships where each member of the partnership is an aforementioned entity. Therefore, the new rules will most commonly apply to individuals and private trusts including SMSF’s.

What are the new rules trying to achieve?

The new rules are designed to address concerns that depreciation deductions claimed by some residential property investors are being overstated. This arises because depreciation claims are being based on valuation reports rather than the actual cost of the depreciable asset. 

What type of assets do the rules apply to?

The Budget Paper indicated that the rules would apply to plant and equipment installed in residential rental properties at the time the premises were acquired. The Bill confirms that the rules will apply to depreciable assets installed in existing residential properties at the time the premises are acquired for rental purposes.  Subject to limited exceptions, the rules will also apply to depreciable assets installed in a property at a time when it was used as a residence rather than a rental property, whether as the main residence or a holiday home.

When do the new rules apply from?

The changes contained in the Bill will apply for the 2016/17 and later income years. The rules will deny a deduction from 1 July 2016 for depreciation in respect of assets in residential premises acquired under a contract entered into after 9 May 2017. 

Can the rules apply to pre-existing properties?

The Budget Paper indicated that residential premises acquired before 9 May 2017 (pre-acquired premises) would be grandfathered. However, as currently drafted, the Bill will deny future depreciation deductions in respect of depreciable assets in pre-acquired premises if no deduction is available in the 2016/17 income year. This would be the case if, for example, the premises were not available for rent for the entire 2016/17 income year.

What about capital works on building structures?

The Explanatory Memorandum (EM) confirms that the new rules do not limit capital works deductions.

What does it mean to carry on a business in order to be excluded from the provisions?

The new rules do not apply to (among others) a person or entity that is carrying on a business. General principles will apply in deciding if a business is being carried on, for example whether holding two properties could amount to a business. Clearly it could be expected that the ATO will seek to apply a stringent test. The EM provides little guidance, other than to point out that the courts have in the past looked at various matters in deciding if someone is carrying on a business, including whether there is a significant commercial purpose or character, whether the activities are repeated and regular and whether the activity is better characterised as a hobby or recreational pastime. 

What are residential premises?

The Bill uses the GST definition of ‘residential premises’. This is a highly sophisticated and developed area of the GST law. Questions of whether a premises is ‘residential’ will now require an analysis of GST case law and ATO guidance which may increase compliance costs for taxpayers. The EM states that land or a building will be considered a residential premises if it provides, at a minimum, shelter and basic living facilities and is either occupied by a person or designed for occupation. We therefore believe that this would include commercial properties being used for residential purposes, hotels, hostels and retirement villages. 

What will be the treatment of the cost of depreciating assets if you cannot depreciate the items?

The Bill confirms that the cost of a depreciating asset that is not able to be depreciated will form part of the CGT cost base of the asset and consequently, a loss (or gain) on the disposal of such a depreciating asset will be on capital account. 

Off the plan property purchases?

The Bill provides for a deduction for depreciation where no other entity has been entitled to claim a depreciation deduction for the asset and either no entity has lived in the premises in which the asset was installed, or the asset was installed within six months of the premises becoming new residential premises.  We believe that off the plan purchasers of property will still be able to claim deductions for depreciation as the developer would not have been entitled to claim a depreciation deduction (as the depreciable asset would be considered their trading stock) and no other person would have lived in the premises before the owner.

Second hand assets?

Deductions for depreciation are denied if you did not hold the asset when it was first used. This essentially requires that the asset must be brand new in order for the owner to claim a deduction for depreciation. Therefore an entity that purchases a second hand asset to install in a rental property would not be entitled to claim a deduction for depreciation.  

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