Are property partners investors or business partners?
In the 2013 Guide for Rental Property Owners, the ATO reviews the position of partners carrying on a rental property business.
The ATO gives an example of a couple who jointly own twenty-six residential rental properties. They spend considerable time to manage the properties personally and derive most of their income from rents. The ATO says that they are carrying on a rental property business.
The ATO gives another example of a couple who own three residential rental properties. They manage the properties personally. They both have full-time jobs and derive some rental income. The ATO says that they are property investors.
In both examples, they couples are co-owners of the properties - the legal title is as joint tenants or as tenants in common in equal 50% shares.
The ATO’s view is that only if partners are carrying on a rental property business can they agree to share rental income and property losses in different proportions to their legal interests in the property. Otherwise, if the partners are merely investors they must share the rental income and property losses equally.
In YPFD and Commissioner of Taxation [2014] AATA 9, a decision of the Administrative Appeals Tribunal of Australia, another dimension of carrying on a rental property business was explored, namely access to ‘work related’ tax deductions.
The Commissioner argued that the taxpayer was an investor, as opposed to a person carrying on a business of letting properties. Therefore, the ATO disallowed deductions claimed for ‘work related’ expense claims such as for property seminars and courses, interest expenses, borrowings expenses, building depreciation, travel and phone.
What is required to carry on a business of letting rental properties?
In YPFD, the taxpayer worked full time as an industrial chemist. She owned nine rental properties jointly with her husband, which had been bought in the 1990s. She used real estate agents to manage the properties. She declared net rental losses of between $27,000 and $57,000 in her tax returns in each of the 2003, 2004 and 2005 years.
The Tribunal adopted the six indicia from Smith and the Commissioner of Taxation (2010) 79 ATR 934 as to what activities constitute carrying on a business. The Tribunal formed the overall impression that YPFD carried on a business of letting rental properties, after considering the six indicia:
- Do the activities have a profit-making purpose?
Tribunal – the intention was to make a profit, even though until now, the properties were loss-making. - The complexity and magnitude of the undertaking;
Tribunal – appointing real estate managers was in order – it was not necessary to collect the rents and manage the properties personally. - An intention to trade regularly, routinely or systematically;
Tribunal – owning the properties over a period of years since the 1990s was sufficient. - Operating in a business-like manner and the degree of sophistication;
Tribunal – the absence of written business plans, and ad hoc advertising for tenants made the taxpayer’s modus operandi unsophisticated and un-business-like; - Does a profit or loss arise from a discernible pattern of trading?
Tribunal – there was a discernible pattern of trading in managing the properties. - The volume of the operations and the capital employed;
Tribunal – the volume of the taxpayer’s operations and the capital employed were significant.
The taxpayer was therefore carrying on a business of letting rental properties and was allowed to make ‘work related’ expense claims.
The Tribunal’s analysis considerably widens the scope for taxpayers with a handful of rental properties to be considered as carrying on a business of letting rental properties. In particular, the properties can be loss-making and a rental property manager can look after them.
What ‘work related’ expense claims did the Tribunal allow YPFD to make?
The Tribunal analysed the expense claims in terms of their nexus (connection) to gaining assessable income from a business of letting rental properties.
- The fees for real estate investment courses, and outlays for audio packs and other educational materials, including travel and accommodation: The taxpayer attended seminar programs and purchased course materials from 10 property education course providers, spending approximately $74,000. The Tribunal restricted the expense claims to the courses which had a nexus to owning existing property, as opposed to courses about buying and selling property, because the taxpayer was not carrying on a business of buying property (having not bought any property since completing the courses).
- Interest expenses to fund the construction of a rental property: The Tribunal restricted the claim to 25% of the total interest paid, because 50% of the borrowing was the husband’s half share and 25% was used for private purposes – to pay a credit card debt.
- Borrowing expenses and Depreciation: these expenses were apportioned according to ownership entitlements of 50%.
- Gardening expenses and repairs and maintenance: these claims failed through lack of documentation.
- Motor Vehicle Expenses: The ‘cents per kilometre’ method was preferred to a log book percentage method.
- Other Work Related Expenses: mobile phone, computer and stationery expenses were accepted, subject to substantiation.
The accumulation of disallowed claims had an adverse effect. That is, the Tribunal found that the taxpayer had failed to take reasonable care in filing her income tax return, and so an administrative penalty of 25% of the tax payable was justified.
Conclusions
Many taxpayers buy investment properties in their own name, because of the ability to offset property losses against salary income to reduce tax payable (negative gearing) and because it is easier to borrow money against a property purchased in their own name.
If so, the YPFD decision helps many taxpayers to claim a wider range of expenses than a property investor enjoys, by deciding that a taxpayer with nine rental properties who outsourced property management is carrying on a business of letting rental properties. The Tribunal left the door open to fewer properties being sufficient, if operated in a business-like manner.
If they are in the business, there is also scope for taxpayers to share rental income and property losses by way of a Partnership Agreement in different proportions to their legal interests in the property.
Apart from the knowledge gained, another benefit may flow from attendance at property education courses, seminars and mentoring programs which teach systematic investing and trading techniques. If the taxpayer puts what they learn into practice, the cost could be claimable as a tax deduction because of its connection with a property business.
This article was first published by Cordato Partners in Lexology which is an international innovative, web-based service that provides over 200,000 company law departments and law firms around the world with a depth of free practical know-how on specialist areas of law © Copyright 2014 Sydney