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On 1 July 2017, changes were made to the tax law in relation to the claiming of depreciation on certain assets used in residential rental properties. Since then, investors in residential rental properties have not been able to claim decline in value deductions in relation to the acquisition of second-hand assets or assets which were previously used for private purposes.

Now that the 2018 tax season is underway, and tax returns for the 2017–18 income year are being prepared and lodged, it is timely to revisit these new rules to ensure that taxpayers do not miss out on rightful deductions or claim amounts to which they are not entitled.

Note Note
For ease of expression, throughout this blog:

  • the term ‘depreciation’ has been used to refer to the tax ‘decline in value’ of a depreciating asset; and
  • the application date of 7.30 pm by legal time in the ACT on 9 May 2017 is referred to as ‘7.30 pm on 9 May 2017’.

Background

Prior to 1 July 2017, a purchaser of a residential rental property would allocate a portion of the purchase price to depreciating assets purchased with the property and claim depreciation deductions under Div 40 of the ITAA 1997.

This created opportunities for successive investors to ‘refresh’ the value of previously used depreciating assets and claim amounts in excess of their actual value or even original cost, resulting in a ‘double dip’ of claims for tax purposes across successive owners of the assets.

How the new rules operate
The Treasury Laws Amendment (Housing Tax Integrity) Act 2017 — which received Royal Assent on 30 November 2017 — addressed this issue by amending the tax law to limit deductions to outlays actually incurred by investors.

Limiting depreciation deductions

Section 40-27(2) reduces the amount a taxpayer can deduct for the depreciation of an asset under Div 40 or Subdiv 328-D of the ITAA 1997 (the small business entity depreciation rules) to the extent that the asset:

  1. is used, or installed ready for use, for the purposes of gaining or producing assessable income from the use of ‘residential premises’ to provide residential accommodation; and
  2. has been ‘previously used’. (emphasis added)

Application date and transitional rule

The rules apply to income years commencing on or after 1 July 2017 for assets:

  • acquired at or after 7.30 pm on 9 May 2017 — unless the asset was acquired under a contract entered into before this time; or
  • first used or installed ready for use before or during the income year that includes 9 May 2017 (generally the taxpayer’s 2016–17 income year) and the asset was used for wholly non-taxable purposes in that year. According to the Explanatory Memorandum (EM) to the amending legislation, this is to avoid creating unintended incentives for individuals to move personal assets into rental properties.

Note Note
This means that the new rules do not apply where the property was held before 7.30 pm on 9 May 2017 and was used wholly or partly for a taxable purpose in the 2016–17 income year.

Implications Implications
Existing depreciating assets used or installed in residential rental properties held before 7.30 pm on 9 May 2017 — or acquired under contracts already entered into at 7.30 pm on 9 May 2017 — and which were used wholly or partly for a taxable purpose in the 2016–17 income year will continue to give rise to deductions for depreciation until either the investor no longer owns the asset, or the asset reaches the end of its effective life.

However, if the property was used solely for a non-taxable purpose in the 2016–17 income year, even if it was rented in an earlier income year(s), no deduction for depreciation is allowed in any later income year for assets that were used or installed in the property as at 7.30 pm on 9 May 2017.

What are ‘residential premises’?

The expression ‘residential premises’ takes on the same meaning as it has in the GST Act. The premises must be land or a building that is either occupied or intended to be occupied — and capable of being occupied — as a residence or for residential accommodation.

Once the character of the premises has been identified as residential premises, a ‘use’ test is applied.

Important Important
The purpose for which the property is held is not relevant. The premises need only be suitable for occupation, rather than long-term occupation. For example, this includes a room that is only suitable for short term accommodation, but does not include a caravan (which is not land or a building) or a hospital (not intended for occupation as residential accommodation).

The depreciation deduction is denied only to the extent that the use of the asset is:

  • attributable to the use of the residential premises to provide residential accommodation; and
  • not in the course of carrying on a business.

Assets used for other income generating activities in the premises will not be affected — e.g. where a certain part of the building was suitable only for commercial purposes (e.g. as a doctor’s surgery) and another part was suitable for residential accommodation.

When has an asset been ‘previously used’?

An asset has been ‘previously used’ if:

  • the taxpayer did not hold the asset when it was first used, or first installed ready for use (other than trading stock) — i.e. the taxpayer purchased it second-hand from another entity; or
  • at any time during the income year or an earlier income year, the asset was first used or installed ready for use, either:

in residential premises that were one of the taxpayer’s residences at that time; or

for a purpose that was not a ‘taxable purpose’ and in a way that was not occasional.

Previous use as trading stock and other purposes

Previous use can cover situations where another taxpayer, such as a property developer, has used an asset in a property both as trading stock and for another purpose.

The EM states that, for example, where a property developer:

  • installs an asset in premises they intend to sell — this will generally constitute use as trading stock; and
  • rents out the property containing the asset while they seek to find a purchaser — the property and hence the asset are used, at least in part, for a purpose other than as trading stock and the asset would be ‘previously used’ in the hands of any subsequent purchaser (subject to the exception for assets used or installed in certain new residential premises).

Previous use in the taxpayer’s ‘residence’

‘Residence’ takes its ordinary meaning. A person may have more than one residence if they commonly occupy, or have available to occupy, two or more residential premises.

According to the EM, a dwelling an entity owns that is currently rented out to a tenant is not generally a residence of the entity at that time (even if it previously had been), whereas a holiday home that is principally held available and ready for the use of an entity may be the entity’s residence at that time.

Implications Implications
This means that the new rules may apply to an asset that was held by the taxpayer and not previously used for a taxable purpose but is later used for a taxable purpose.

Previous use for a non-taxable purpose, other than occasional use

An asset will not be previously used if it has only occasionally been used for a purpose that is not a ‘taxable purpose’ within the meaning of Div 40. A ‘taxable purpose’ is defined in s. 40-25(7) as including the purpose of producing assessable income (amongst other things).

Use for a purpose is ‘occasional’ where the use is infrequent, minor and irregular. For example, according to the EM, spending a weekend in a holiday home or allowing relatives to stay free of charge for one weekend in the holiday home that is usually used for rent would generally be considered ‘occasional’ use.

Exceptions
Depreciation deductions are not denied under the new rules in any of the following circumstances:

  1. the taxpayer is an ‘excluded entity’;
  2. the asset is installed in new residential premises, and certain other conditions are met; or
  3. the asset is used in carrying on a business.

Exception 1 — Excluded entities

Excluded entities are:

  • a corporate tax entity (i.e. a company);
  • a superannuation fund other than an SMSF;
  • a managed investment trust;
  • a public unit trust; or
  • a unit trust or partnership, where each unit holder/partner is one of the above entity types.

Exception 2 — New residential premises

‘New residential’ premises has the same meaning as in s. 40-75 of the GST Act — i.e. includes premises that have:

  • not previously been sold as residential premises (and have not previously been subject to a long-term lease); or
  • been created through ‘substantial renovation’ or replacement of existing premises.

Note Note
‘Substantial renovations’ broadly means renovations in which substantially all of a building is removed and replaced. The installation of a new kitchen and bathroom is not, on its own, a ‘substantial renovation’.

The following five conditions must be satisfied to access this exception which is limited to circumstances where the asset is substantially new:

  1. the residential premises are supplied to the taxpayer as new residential premises on a particular day;
  2. the asset is supplied as part of that supply of the premises;
  3. when the taxpayer first holds the asset as a result of that supply, the asset is used or installed ready for use in the premises (or any other related real property in which an interest is supplied to the taxpayer);
  4. at any earlier time, no one was residing in any residential premises in which the asset was used or installed ready for use at that earlier time — except where the new residential premises (or related real property) was supplied within six months of the premises becoming new residential premises; and
  5. no entity has previously been entitled to a deduction for depreciation of the asset under Div 40 or Subdiv 328-D.

This exception essentially allows investors to purchase new residential premises from property developers without being subject to the new rules.

Exception 3 — Asset is used in carrying on a business

Deductions continue to be available for assets used in the course of carrying on a business for the purpose of producing income from the use of residential premises for residential accommodation — e.g. a taxpayer operating a hotel can deduct the decline in value of depreciating assets used for the purposes of the business in the hotel premises.

There is much commentary on what constitutes ‘carrying on a business’ which will not be considered here. Whether a taxpayer is carrying on a business is a question of fact, but ordinarily, the ATO would generally not regard, for example, a property owned by an individual taxpayer in the form of the provision of short-term or long-term accommodation as a business. The outcome would be different if the property were owned by a company (see the ATO’s draft ruling TR 2017/D7).

To which assets do the new rules apply?
The table below summarises when the new rules do and don’t apply.

Cannot claim  Can claim 
 New rules apply to limit depreciation   New rules do not apply
Acquire a property on or after 7:30pm on 9 May 2017 that has not been ‘previously used’ Acquire a new property on or after 7:30 pm on 9 May 2017 that has not been  ‘previously used’ (e.g. purchased new from a builder)
Replace an existing depreciating asset with a second-hand asset Replace an existing depreciating asset with a new asset
Property held before 7:30pm on 9 May 2017 and used wholly in 2016-17 for a non-taxable purpose Property held before 7:30pm on 9 May 2017 and used wholly or partly in  2016-17 for a taxable purpose

 

Example 1

Craig has acquired an apartment that he intends to offer for rent. This apartment is three years old and has been used as a residence for most of this time.

Craig acquires a number of depreciating assets together with the apartment, including carpet that was installed by the previous owner. He also acquires a number of depreciating assets to install in the apartment immediately prior to renting it out, including:

  • curtains, which he purchases new from Retailer Co; and
  • a used washing machine that he purchases from a friend, Jo.

Craig also purchases a new fridge, but rather than place this in the newly purchased apartment, he uses it to replace his personal fridge, that he acquired a number of years ago for use in his home. He instead places his old fridge in the apartment.

Treatment of depreciable assets

The carpet, the washing machine and the fridge

The amendments do not permit Craig to deduct an amount under Div 40 for the decline in value of the carpet, the washing machine or the fridge for their use in generating assessable income from the use of his apartment as a rental property because all of these assets have been previously used.

The carpet and the washing machine have been previously used by the previous owner and Jo who first used or installed the assets (other than as trading stock), rather than Craig. The fridge is taken to be previously used because, although Craig has first used or installed the fridge, he has used it in premises that was his residence at that time.

The curtains

The amendments do not affect Craig’s entitlement to deduct an amount under Div 40 for the decline in value of the new curtains. They are not ‘previously used’ under either limb of the definition.

Source: Example 2.1 of the EM

Other tax implications
Application to small business entities

As noted above, there is an exception where the asset is used in carrying on a business.

Where a small business entity (SBE) chooses to calculate depreciation deductions using Subdiv 328-D rather than Div 40, Subdiv 328-D must be applied to all assets held by the SBE for a taxable purpose, even those not used in carrying on a business (s. 328-175).

There may be limited situations where an SBE holds assets used in gaining or producing assessable income from the use of residential premises to provide residential accommodation other than in the course of carrying on a business. In these circumstances, s. 328-175(9A) will operate to deny depreciation deductions under Subdiv 328-D.

Application to low-value pools

The Div 40 rules which govern the allocation of eligible assets to a low-value pool require the taxpayer to estimate the percentage of the total use of an asset that would be for a taxable purpose. Only this percentage of the value of the asset can be placed in the pool (s. 40-25(5)).

Where an asset is estimated to be put to a use for which s. 40-27 prevents a deduction being available, that ‘use’ will be for a purpose that is not a taxable purpose (s. 40-435(2)). This reduces the taxable purpose proportion for such assets and also the amount that will be included in the
low-value pool (to be deducted).

Future balancing adjustments and CGT consequences on sale of the propertyTax consequences will arise when the taxpayer sells, or otherwise ceases to hold, the property and/or the depreciating asset.

Where deductions have been reduced under s. 40-27, then at the time the asset ceases to be held:

  • the amount of any balancing adjustment is reduced; and
  • the proportion of the depreciation of the asset that cannot be deducted is recognised as a capital loss (and in some cases, a capital gain) under CGT event K7.

Balancing adjustment

The balancing adjustment amount (as calculated under s. 40-285) is reduced by the proportion of the depreciation that the taxpayer has not been entitled to deduct under s. 40-27.

This is consistent with the treatment of balancing adjustments for assets for which a taxpayer has not been able to deduct amounts because the asset has been used for a purpose other than a taxable purpose.

CGT event K7

Background Background
CGT event K7 happens if a balancing adjustment event occurs in relation to a depreciating asset that has at some time been used for a purpose other than a taxable purpose. Unlike most CGT events, a capital gain/loss from CGT event K7 is not disregarded if it happens in relation to a depreciating asset that a taxpayer holds.

The amount of the capital gain or loss includes the proportion of the depreciation of the asset (that is, the difference between the termination value of the asset and its cost) that the taxpayer has not been able to deduct because of s. 40-27.

Example 2

Gunther purchases a two year old property for $500,000 on 10 July 2017. Part of the purchase price relates to six previously used depreciating assets that are included with the residential premises.

The assets are worth $1,000, $3,000, $4,000, $6,000, $7,000 and $9,000, respectively, for a total of $30,000.

Gunther rents out the property. He is unable to deduct the decline in value of any of the depreciating assets he acquired with the property as they are previously used.

On 10 May 2021, Gunther sells the property, including these depreciating assets, for $700,000. At the time of sale, the six depreciating assets have a value of $0, $1,000, $3,000, $4,000, $5,000 and $7,000, respectively, so in total $20,000 of the sale price relates to the depreciating assets.

The sale of the property is a balancing adjustment event.

As Gunther has not been able to deduct any amount of the decline in value of the depreciating assets, Gunther does not need to make any adjustment to his assessable income for the income year.

However, as a balancing adjustment event occurs in relation to depreciating assets for which the available deduction has been reduced by these amendments, CGT event K7 occurs.

As a result of CGT event K7 occurring, Gunther has a capital loss equal to the proportion of the decline in value of the assets that Gunther has not been able to deduct either because of these amendments or because the amount deductible was reduced under s. 40-25.

In this case, the difference between the total termination value of the assets ($20,000) and the total cost of the assets ($30,000) is $10,000 and all deductions for the decline in value have been denied (so the proportion of total deductions denied is $10,000/$10,000 or 1).

Therefore, the amount of Gunther’s total capital loss because of the disposal of all of the assets is $10,000 [i.e. ($30,000 – $20,000) × 1 = $10,000].

Source: Example 2.3 of the EM

Example 3

Shelley purchases a five year old property for $700,000 on 18 August 2017. Part of the purchase price relates to five previously used depreciating assets that are included with the residential premises.

The assets are worth $5,000, $15,000, $20,000, $25,000 and $35,000, respectively, for a total of $100,000.

Shelley rents out the property. She is unable to deduct the decline in value of any of the depreciating assets she acquired with the property as they are previously used.

On 5 April 2022, Shelley sells the property, including these depreciating assets, for $1 million. At the time of sale, the five depreciating assets have a value of $0, $5,000, $10,000, $15,000 and $20,000, respectively, so in total $50,000 of the sale price relates to the depreciating assets.

On the sale of the property, CGT event A1 happens and there is a balancing adjustment event.

CGT event A1

Shelley will make a capital gain of $350,000 calculated as follows:

Sale proceeds in respect of the property $950,000
Less: cost base of the property (other costs of acquisition and disposal have been ignored in this example ($600,000)
Capital gain $350,000

 

Balancing adjustment event

As Shelley has not been able to deduct any amount of the decline in value of the depreciating assets, Shelley does not need to make any adjustment to her assessable income for the income year.

However, as a balancing adjustment event occurs in relation to depreciating assets for which the available deduction has been reduced by these amendments, CGT event K7 occurs.

As a result of CGT event K7 occurring, Shelley has a capital loss equal to the proportion of the decline in value of the assets that Shelley has not been able to deduct either because of these amendments or because the deductible amount was reduced under s. 40-25.

In this case, the difference between the total termination value of the assets ($50,000) and the total cost of the assets ($100,000) is $50,000 and all deductions for the decline in value have been denied (so the proportion of total deductions denied is $50,000/$50,000 or 1).

Therefore, the amount of Shelley’s total capital loss because of the disposal of all of the assets is $50,000 [i.e. ($100,000 – $50,000) × 1 = $50,000].

Net tax outcome

Shelley has a taxable capital gain from CGT event A1 happening to the property of $350,000, which she reduces by the capital loss from CGT event K7 of $50,000, resulting in a net capital gain of $300,000 which is eligible for the CGT discount because she has held the property for at least 12 months.

How does this compare with the old rules?

Had the new rules not applied to Shelley’s property, she would have had a taxable capital gain of $350,000 which would have been eligible for the CGT discount, and she would have claimed a deduction for depreciation of $50,000.

Accordingly, Shelley is worse off under the new rules because she is longer entitled to claim the $50,000 deduction for the depreciation, and (while she can recognise a capital loss of $50,000) her discount capital gain has been reduced from $350,000 to $300,000, thereby reducing the amount of the CGT discount.

So, what should taxpayers look out for?

It will be important to identify:

  • whether the property constitutes ‘residential premises’ that are used for the purposes of gaining or producing assessable income to provide residential accommodation;
  • when the property was acquired;
  • whether the property is owned by an excluded entity;
  • whether the asset in the property is used by the taxpayer in carrying on a business;
  • if the property was acquired before 7.30 pm on 9 May 2017 — whether the property was used wholly or partly for a taxable purpose in the 2016–17 income year;
  • if the property was acquired on or after 7.30 pm on 9 May 2017 — whether the property was acquired as new residential premises where no-one was residing in the premises and no entity has previously been entitled to a deduction for depreciation of the assets in the property; and
  • whether assets acquired on or after 7.30 pm on 9 May 2017 have been previously used (i.e. whether they are second-hand when they are acquired).

These new rules are likely to increase compliance costs for taxpayers as they prepare their 2018 tax returns, but it will be necessary to consider whether depreciation claims that were allowable in earlier income years are now prevented from 1 July 2017 by these new rules.

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