Are Residential Landlords Leading the Way on Income Tax Non-Compliance?

In his October 2022 speech to The Tax Institute’s Tax Summit, the second commissioner of taxation at the Australian Taxation Office (ATO), Mr Jeremy Hirschhorn, outlined the tax gap and the taxpayer groupings that contribute to that gap. The tax gap is the amount of income tax revenue that is not collected from taxpayers, and which should have been collected if the tax law was applied correctly. In 2018-19 the estimate of the tax gap is roughly $33 billion, or 7% of the proper tax collection. The biggest contributor to the gap was the small business sector, worth $12 billion.

When it comes to residential rental property owners, often mums and dads, Mr Hirschhorn said the contribution to the tax gap is around $1 billion. He went on to say that data suggested that 9 out of 10 tax returns reporting net rental income required adjustment. He went on to say, “this is startling and clearly something we need to address”.

Two points should be noted about the data, which is gathered from the ATO’s random enquiry of individuals not in business, which includes residential rental property owners. First, both tax agent prepared returns (80%) and taxpayer prepared returns (61%) required adjustment. Secondly, around 10% of the adjustments actually resulted in less tax payable.

A persistent issue

Regrettably, the poor compliance rate has been the position for residential rental property owners for many years as evidenced by the raw numbers and the regular targeting of ATO audit activity at the sector. That is, there is persistent and entrenched non-compliance (in truth in many situations, tax cheating or tax evasion).

The behaviour includes:

• not declaring rental income,
• not declaring the capital gain on sale of the property,
• claiming the main residence exemption under the capital gains tax for the profit on sale of a rental property,
• claiming interest deductions when a property is not truly available for rental (for example, holiday homes),
• claiming capital expenditure as an immediate deduction,
• declaring all rent income and claiming all deductions to one spouse when the loss-making property is co-owned,
• claiming deductions for the full cost of travel to a property when the travel was partly for private purposes such as holiday.

It got so bad that in some expenditure areas, even the government and the parliament eventually “threw their hands in the air” as if to say, enough is enough. In and around 2017 to 2019, the Australian Government and the Parliament enacted two deduction denial rules (sections 40-27 and 26- 31 of the Income Tax Assessment Act 1997) that are targeted at transactions in this sector. A third denial rule (section 26-102) was also in part targeted at, or operated in, this sector.

The three deduction denial rules

Section 40-27 denies residential rental property owners a depreciation deduction in circumstances where they commence to use a second-hand asset in their rental property. These circumstances can occur either by taking a private asset from one’s home and placing it into a rental property or by purchasing a rental property with used assets in it. The denied deductions may now give rise to a capital loss under the capital gains tax regime.

Before the enactment of section 40-27, depreciation deductions for use of a second-hand asset were available under the tax law provided the asset was used in the rental property. What occurred on a large scale was that when the second-hand asset was put to use in the property, the taxpayer, undoubtedly in many cases on tax agent’s advice, was resetting the base on which to claim depreciation deductions. The resetting was often to even more than the market value of the asset. The same point applies on purchase of a second-hand asset (usually along with purchase of the property). In the purchase situation, often a quantity surveyor would provide an inflated estimate of the purchase cost of the depreciating asset from amongst the total single price paid for the rental property. In short, the resulting depreciation deductions claimed by the taxpayer were much greater than the law allowed.

Section 26-31 denies deductions for travel to and from a rental property (for example, to inspect the property or to arrange a repair). Under the old rule, there can be difficulties in determining the correct deduction portion where the travel had two purposes or aims, for example to take a holiday and visit to inspect the rental property. The law had a reasonable apportionment rule. What in fact happened, of course, many property owners and their tax agents were not making reasonable apportionments into deductible and non-deductible components.

Section 26-102 denies deductions for revenue expenses (most significant being interest on loan) associated with holding vacant land or holding land on which construction of a dwelling (or substantial renovation) is involved, until the dwelling is completed and fit and available for rent. Before this, the tax law generally did allow such deductions provided there was a real commitment to constructing the dwelling and renting it out within a “reasonable” time frame. Deductions now denied under section 26-102 can, nevertheless, be included in the cost base of the land for capital gains tax purposes.

In these three instances, improving the integrity of the tax system was mentioned amongst the official reasons. For example, for section 40-27, The relevant minister said in his second reading speech, we have seen significant abuse of the tax system with property investors claiming excessive deductions on second-hand assets, and that this change will improve the integrity of the tax system.

Are the rules justifiable?

There are many provisions denying deductions in our tax law where the expense would otherwise be deductible. However, I cannot recall any other instance under the income tax where a deduction denial provision is enacted solely on the basis that the taxpayer grouping involved will not comply with the tax law, and the ATO cannot seem to attain sufficient compliance.

This is clearly the case with section 40-27 which denies depreciation deductions for second-hand assets. There is no or at least minimal grey area here and any diligent registered tax agent should have been capable of getting this right, sometimes perhaps with a little basic research. The same applies to section 26-31. Although it can be difficult to get a high degree of precision in apportionment of expenses where dual purpose travel is involved, the ATO and the courts do not require a high degree of precision when it comes to apportionment. Similar comments can be made in respect to situations prompting section 26-102 in relation to deductions for vacant land.

What has happened with these three provisions is that otherwise legitimate deductions are now being denied across the board. It is a big step to take away deductions for legitimate income-producing expenses to a whole taxpayer sector or taxpayer grouping based on the non-compliance of a segment of taxpayers in that grouping. On the other hand, when a substantial proportion of the segment refuses to comply, then there is a case for treating the segment as a collective, albeit unfair to the small proportion that are complying.

In truth though, while the above areas of expenditure now denied deductibility are somewhat significant, there remains other major compliance problems in this sector such as undeclared rental income, undeclared capital gains, claiming interest expenses on holiday homes and claiming capital expenditure like renovations or upgrades as an immediate deduction. It would be helpful if the Government and the Parliament could provide “some assistance” in these areas.

One does not want to be too critical of the ATO because it is a highly respected regulatory agency and arguably, under-resourced. However, one can legitimately ask how the ATO can be so ineffective over such a long time in detecting and correcting non-compliance among residential rental property owners. There may be factors about this group that are particularly difficult. One positive development is that back in 2015, supported by its information gathering powers, the ATO requested property ownership records held by state and territory governments so that it could pursue more comprehensive data matching. The requested records date back to 19 September 1985; this is the start date of the capital gains tax regime. Given the persistent high non-compliance rate, one must however wonder how helpful this has been.

It should also be borne in mind that individual investors in residential property face a generous tax regime, mainly in the form of negative gearing and the 50% capital gains tax discount.

Are residential landlords leading the way?

The answer to my initial question in the title requires the selection of applicable comparative criteria and a comparative analysis on such things as overall amount of lost revenue, is the non-compliance tax agent-driven or taxpayer driven, and number of taxpayers in the sector who are cheating. It should be noted that the tax gap in the small business sector (with a much larger population and revenue base) is estimated to be around $12 billion.

However, if the focus is on the proportion of taxpayers in the sector that are not complying and the persistence of non-compliance over time, we can safely say that residential rental property owners, as a collective, are competing hard to be leading this anti-social activity.

 

A version of this article first appeared on UNSW’s BusinessThink.