- Limiting tax deductions for vacant land
Following the federal budget announcement in 2018, tax law set to deny a deduction for the costs of holding vacant land in specified circumstances has been passed without amendment by the House of Representatives, and now moves to the Senate.1
The new rules will apply to individuals, trusts (which are not widely held) and to self-managed super funds (SMSF’s). They will not apply to companies, managed investment trusts, public unit trusts or super funds other than SMSF’s.
Current income tax law allows those who hold vacant land to claim a tax deduction for the costs of holding the land if it is held for income-producing purposes, or if they are carrying on a business to produce income.
Broadly, under the new law, a deduction for the costs of holding vacant land will be limited to land (or significant structures on the land) that are utilised in a business or available for rent.
The new law applies to costs incurred on or after 1 July 2019, regardless of whether the land was held prior to this date.
Land will be considered vacant under the new law if there is no substantial and permanent building or other structure on the land which is in use, or available for use, with an independent purpose that is not incidental to another structure.
Examples given of structures which may have an independent purpose include a commercial parking garage, a woolshed and a grain silo, all of which have a separate primary use. A residential garage or shed, on the other hand, would not have an independent purpose.
Holding costs include ongoing borrowing costs, interest incurred for loans to acquire the land, land taxes, council rates and maintenance costs.
Where only part of the land is used for a business purpose, then apportionment is required on a fair and reasonable basis.
Costs which are not deductible as a result of the amendments may be included in the cost base of an asset for CGT purposes which will give relief against any capital gain or loss when the taxpayer ultimately sells.
There is an exclusion to the rules in that a deduction will not be denied for holding costs to the extent that they are incurred in carrying on a business (eg a property development or primary production business) by the taxpayer, or in some instances, their related entities or affiliates.
The leasing of land to related parties is common in the agricultural sector for family enterprises and this ensures they are not adversely affected – however, the concession is limited to certain family relationships (eg spousal or children, but not siblings).
The exclusion also covers land which is held available for future use in a business and therefore provides relief for property developers holding vacant land for future development.
A special rule applies when determining whether land that contains residential premises is vacant. Land will be treated as remaining vacant for the purposes of these amendments until the residential premises are (or are available to be) leased, hired or licensed.
This rule means that a taxpayer cannot deduct the costs of holding land containing residential premises (or construction thereof) until they are actively seeking to derive income from its use i.e. it is available for rent and placed on the rental market.
Special Rule for Residential Premises
The example given in the Explanatory Memorandum is as follows:
Anna purchased a block of vacant land and built a new residential premises on it. Occupancy permits are issued for the residential premises once the building is considered suitable for occupation and the building is actively made available for rent.
Anna can deduct the costs of holding this block of land to the extent expenses are incurred once the property is legally available for occupation and is leased, hired or licensed or otherwise available for lease, hire or licence.
Grant Thornton Comment
The new law is likely to have far-reaching consequences and catches taxpayers and circumstances which were not the obvious target when the changes were initially announced.
For example, the new law is likely to have a significant impact on individuals and trusts who borrow to acquire land on which residential property is to be developed for rental investment purposes. Borrowing costs (including interest) are a significant expense, and will now only deductible when the property is complete and being marketed for rent. Costs incurred prior to that point will only obtain tax relief when the property is sold, as part of the cost base for capital gains tax purposes. This loss of up-front tax relief will have the cash-flow and financing impacts that will need to be factored in – which will be difficult for projects that are already underway at the effective date.
Whilst there is a welcome relaxation of the rules to allow deductions where land is acquired for a business purpose of the taxpayer or is leased to related entities for that purpose, the new rules will deny a deduction for landowners who lease to unrelated parties or outside their immediate family. Consider the investor who borrows to acquire vacant land to lease at arm’s length to a third party, perhaps for the purposes of farming or rearing livestock. A deduction for interest incurred on the loan will no longer be available. There appears to be no mischief caught by denying such tax relief when an arm’s length rental income is earned and taxed. The investor will no doubt want to consider how they can recover their consequential loss, perhaps by way of increases in the rent where that is possible under the lease.
The rules do not apply to companies, and whilst it may now seem attractive to structure an acquisition using a corporate entity, this will come at the cost of the 50% CGT discount which is not available to companies.
However, where holding costs are deducted after 1 July 2019 on vacant property that is not being utilised within a business other than property development, the taxpayer will likely have given up eligibility to utilise the 50% CGT discount on a future sale. Where deductions are claimed, the ATO will draw the conclusion that land is being held for revenue purposes rather than on capital account.
The new rules are not retrospective but will nevertheless adversely affect a significant group of taxpayers who have had their investments and business structures in place for a number of years. They may now find that the tax changes adversely affect commercial viability and they need to pass on the additional tax cost to their customers/tenants, or even consider divesting completely. We would prefer to see some grandfathering provisions to shelter taxpayers who have already committed to a course of action. Investment decisions are inevitably based on after tax outcomes that will now need to be reassessed.
If you feel you may have investments or holdings that will be impacted by the changes, please get in touch with your Grant Thornton Tax or Relationship Partner.
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1 Schedule 3 to the Treasury Laws Amendment (2019 Tax Integrity and Other Measures Bill No. 1) Bill 2019 (Cth)