Chapter 5 - Using ring-fenced losses

5.1 Under the suggested changes, ring-fenced residential rental or other losses from one year would could be offset against:

• residential rental income from future years (from any property); and
• taxable income on the sale of any residential land.

5.2 Most residential rental investors are not subject to tax on the sale of their investment properties under current tax rules. However, in some circumstances, the sale of a residential rental property may be taxed under one of the land sale rules in the Income Tax Act – or the taxpayer may have taxable income on the sale of other residential property (not rented out). This could be the case, for example, because the taxpayer is in a land-related business (for example, a land dealer or developer), bought the land for resale, or sells the property within the bright-line period of either two or five years (depending on when they first had an interest in the land).[9]

5.3 Under the suggested changes, where a taxpayer sells a property that is subject to the ring-fencing rules (that is, a residential property) and the sale is taxed, any ring-fenced losses the taxpayer has could be used to reduce the taxable gain on sale to nil. Any remaining unused losses would stay ring-fenced, and could be used against any future residential rental income or taxable income on other residential land sales.

5.4 There is an argument that in the case of a property with ring-fenced losses that is taxed under one of the land sale rules on disposal, the losses should be able to fully utilised (that is, un-fenced) at that point, and be used to offset any other income of the taxpayer. This would reflect that all of the economic income from the investment has been taxed (the rental stream and the capital gain), and that the investor should not be penalised for making an overall loss on the investment.

5.5 However, if the rules are to apply on a portfolio basis, as suggested, allowing accumulated losses to give rise to a tax loss on a disposal subject to one of the land sale rules would create risks. For example, it would enable a portfolio investor to sell a property that has made a small capital gain within the bright-line period, offset that gain with ring-fenced losses from across their portfolio, and apply any remaining losses from the portfolio against other income. While there are ring-fencing rules in relation to the bright-line test, they only apply to deductions for the cost of the land, not other costs.

5.6 Enabling taxpayers to sell their lowest capital gain makers within the bright-line period and access what might be substantial portfolio-wide accumulated ring-fenced losses would significantly undermine the credibility of the rules.

5.7 For this reason, we propose that where a disposal is caught by one of the land sale rules, ring-fenced losses should be allowed to be used only to the extent they reduce the taxable gain to nil, with any further unused losses remaining ring-fenced.

9 The bright-line period is two years if you first acquired an estate or interest in the land on or after 1 October 2015, but is five years if you first acquired an estate or interest in the land on or after the date the Taxation (Annual Rates for 2017–18, Employment and Investment Income, and Remedial Matters) Act 2017 is enacted.