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Residential Rental Losses: Not Created Equally

With interest rates rising and the economy tightening, there is a risk you might make a rash decision and sell your rental property without doing the numbers.  If by chance you sell at a loss there is risk you will not have access to those losses.



Residential property - two types of losses

Within the Brightline rules there are two types of losses, and they are treated differently.  They are not necessarily accumulated when you sell your property.

  • Ring-fenced residential rental deductions

  • Capital Losses (from the sale of property)

    • Which may include previously denied interest deductions.


Understanding and applying the legislation associated with residential rental sale transactions can be extremely complex.  We recommend you seek professional advice before purchasing a property, selling your property, and with the preparation of your income tax return.  We have seen a number of instances where calculations have been incorrect.


The critical decision from the start

In your first tax return, you must decide how you will classify your investment.  You have the choice of portfolio or individual property basis (or a combination of both).


You must calculate your residential income and the total deductions you can claim for the year either as an investment identified as a portfolio or as an individual residential property.


Portfolio basis

Under the portfolio basis, you calculate your income and deductions across a residential portfolio, from the filing of your first income tax return until you dispose of the last property included in the portfolio. Over time, the properties in your portfolio can change from year to year as they are bought and sold.


Individual property basis

When you elect the individual property basis, you apply the rules to each property separately. This means the deductions for an individual property can be offset only against the income from that property. You can have multiple properties, each elected to be an individual basis property.  When you prepare your income tax return, you calculate the income and deductions for each property separately.


If you have expenses that relate to more than one property, such as interest on a loan used for multiple properties, the individual property basis cannot be used.


You can decide at any time to move to the portfolio basis, but once you start using the portfolio basis, you must continue to use this method.


Portfolio versus Individual: An important distinction – your ability to access losses (or not)

  • Under an individual property basis, the expenses of one property can not offset income from other properties.  If a property was sold within the brightline period and a loss was incurred, the ring-fenced losses for that property can be released and offset against other taxable income.


  • The portfolio basis is not so generous.  The expenses of one property can offset income from other portfolio properties.  When a property is sold within the brightline period and a capital loss (loss from property sale plus interest) is incurred there are restrictions on the ability to release ring-fenced losses on the taxable sale of a property.  (Essentially trapping the losses).

Bright-line capital losses (Portfolio Basis)

Where a loss is incurred from the sale of residential property, you can only offset the loss against net income from another property sale. Any remaining loss can only be used in a future year when you have net income from another property sale*.  The capital loss is not able to be applied against earning residential rental portfolio income or other income.


What this means is that you can apply the loss to the gain made from a property which is bought and sold, i.e.

1.     If residential property within the Brightline rule period; or

2.     Land transactions acquired for business purposes i.e. intention of resale.

 

The critical point here, is that the capital loss can not be applied against the net surplus from having portfolio property (as it can if recorded as an individual property).


Pause before selling

Depending on your perspective, selling a property can be exciting when contemplating the cash flow it may free up, equally it may be stressful as you contemplate a cash flow deficit.  Irrespective of your position or perspective, we strongly recommend you seek professional advice before selling so that you are aware of your potential tax obligations or exposure to trapped losses.

 

*Losses can be applied to any land that is taxable under the land taxing provisions i.e. revenue account property.


This article is for informational purposes only and should not replace specific tax advice. For personalised advice please contact Justine Kennard, Business Studio.

 

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