When do residential rental activities amount to a business? A recent ruling shows owning as few as five residential rental properties will change your tax status significantly

By Lindsay Ng*

[This article was first published in The Journal, an NZICA publication. It is used here with permission.]

Inland Revenue (IR) has had a win in the Taxation Review Authority (TRA) where it was held that the ownership of five residential rental properties amounted to the carrying on of a business.

As a result the rental losses derived, which had been included by the taxpayer in calculating her entitlement to Working for Families tax credits (WfF), were disallowed.

The facts

The facts in TRA 012/11 are summarised below.

• The taxpayer is a self-employed artist who is married with five children. She registered for WfF in April 1999.

• In the course of a tax investigation IR discovered that the taxpayer owned five residential rental properties in partnership with her husband.

• The properties were purchased between April 2003 and September 2007 with small deposit amounts.

• The taxpayer engaged a property manager to manage the five rental properties in December 2007.

• An accountant was engaged to prepare rental accounts and tax returns.

The key issue to be determined in the TRA was whether or not the residential rental activities amounted to a “business” as defined in section OB 1 of the Income Tax Act 2004. This is because, under the WfF rules applicable to this case, losses incurred from investment activities could be taken into account for WfF purposes but business losses could not.¹

Generally whether or not activities carried on by a taxpayer amount to a “business” involves consideration of whether or not there was an undertaking carried on for pecuniary profit. The term “pecuniary profit” is not legislatively defined; however, its meaning has been considered in case law.

Commissioner’s arguments

The Commissioner argued as follows.

• The taxpayer’s residential rental activities amounted to a business. This conclusion is drawn from:

- the overall nature of the rental operation

- the nature and scale of the operation

- the investment of time, money and effort

- the real and potential profit derived.

• “Pecuniary profit” cannot be equated with a profit for tax assessment purposes.

• The taxpayer’s asserted intention that the rental properties were held for long-term capital gains needed to be assessed against objective factors. These factors (above) supported the conclusion a business was being carried on.

• In this case the WfF rules were exploited and this factor is also relevant when establishing whether or not the taxpayer intended to make a “pecuniary profit”.

Taxpayer’s arguments

The taxpayer argued that despite accepting a rental property operation involving the number of properties in this case can amount to a business, there was no business for the following reasons

• It was understood the level of mortgages on each property and the running and maintenance costs of each property would mean losses would be made; therefore, there was no prospect of a revenue profit.

• The investment properties were purchased to give her children an investment that has grown in value (that is, a capital gain); therefore, there was no intention to make a “pecuniary profit”.

• “Pecuniary profit” does not include a capital gain, it being capital and not revenue in nature.

• The desire to make capital gains cannot convert an activity into a business.

• The taxpayer’s activities were inconsistent with a business pattern and she sought to increase her wealth by capital gain and not by earnings.

Decision

The TRA agreed with the IR. In reaching this decision the following factors were considered:

• Nature of the activity – conceded by the taxpayer to be able to amount to a business and held to be so in this case. Also the taxpayer’s activity encompassed operating a structure to seek capital profits.

• Period over which activity is engaged – five rental properties acquired in a two-year period with no indication the operation will be terminated.

• Scale of operation and volume of transactions – management of maintenance, mortgage payments and tenancy agreements on five or six properties; capital value of rental properties exceeded $750,000 (a sizeable financial commitment for a person with income of less than $60,000); reliance on rental payments and WfF to service the mortgages.

• Commitment of time, money and effort – financial commitment was significant and need for use of property manager relevant.

• Pattern of activity – WfF entitlements increased dramatically during the time three to four rental properties were purchased. The pattern of activity and the taxpayer’s own evidence showed the incentive of higher WfF payments was a key motivating factor for the structure of the activity.

• The financial results – assessable rental income was derived, rental losses were used to increase WfF entitlements, and there was potential for long-term capital or equity gains. Each of these indicated an increase in the taxpayer’s wealth by profit in money’s worth.

• The taxpayer’s intention – capital profit is pecuniary profit in the context of this case. The taxpayer had an intention to profit from the rental activities.

• Type of profit – the meaning of “pecuniary profit” is not restricted to a taxable profit.

Further, the TRA stated, through the scale and structure of the rental operation, undertaken in view of the WfF payments available where income is reduced by losses, the taxpayer has obtained money or money’s worth. Overall, the taxpayer’s activity is geared with an intention for pecuniary profit.

Food for thought

The TRA decision raises a number of practical issues.

Relationship between pecuniary profit and non-taxable capital profit

The TRA decision suggests pecuniary profit includes capital profit that is not otherwise assessable under the Income Tax Act 2007 (ITA07). This conclusion is not consistent with the scheme and purpose of the taxing provisions in the ITA07 where, unless otherwise provided, tax is payable on receipts of income, not capital.

Further, the purpose of the business test is to determine a point in time in which a person’s activities are to be brought to tax.

Such an interpretation appears to extend the principles established by the Court of Appeal in Grieve v CIR (1984) 6 NZTC 61,682 and CIR v Stockwell (1992) 14 NZTC 9,190. In Grieve Richardson J in the Court of Appeal stated that the crucial factors are the character and circumstances of the particular venture. In Stockwell Cooke P in the Court of Appeal stated that in a grey area case he would lean against a finding of a business².

It would seem a step too far to suggest that the business test equates “pecuniary profit” (taxable) with “capital profit” (non-taxable). Whether or not a person is carrying on a business is very much a question of fact in each case.

Dividing line between “investment activities” and “business activities”

Under a self-assessment system a taxpayer must determine their income tax liability. The decision in TRA 012/11 raises the question of what criteria would be hallmarks of an investment activity or a business activity. At what point would an investment activity cross the line to become a business activity?

Coincidentally IR published a statement in Tax Information Bulletin Vol 6, No 3 (September 1994) in the context of WfF:

“For income tax purposes, rental losses are deductible in full. However, a person cannot be said to be in the ‘business of renting’ unless there is an intention of making a profit from the rental activities. Often, the mere holding of property to derive rental income does not constitute a business.
Factors to be considered in determining whether a taxpayer is ‘in the business of renting’, or if the rental activity is of a non-business nature include:

• the scale of the operation and the volume of transactions. A taxpayer who owns several rental properties is more likely to be ‘in the business of renting’ than a person with only one property.

• the commitment of time, money and effort. Comparing these with operations normally involved with an operation that has been determined as a ‘rental business’.

• the pattern of activity and the financial results. A profit is not likely to be as important to a person acquiring a property for investment purposes; for example the rental income is used to offset the costs of owning the property, such as rates, insurance etc.

Example 1
A taxpayer borrows a substantial amount of money, and uses it to buy a house for investment as part of a retirement plan. The house is rented at a market rental, but the interest exceeds the rental income earned. The rental loss is deductible for Family Support purposes.

The taxpayer is not in the business of renting because the property has been acquired as part of a retirement investment plan, and the commitment of time and effort in collecting the rent, maintaining the property etc is less than would normally be involved in a ‘rental business’.

Example 2
A taxpayer owned two houses and a block of five flats. She collected the rents, interviewed tenants, and did some of the maintenance and repair work. The Taxation Review Authority in Case F111 (1984) 6 NZTC 60,094 held that the taxpayer was carrying on the business of a landlord.

The rental loss is not deductible. For Family Support purposes the loss is treated as nil.

It cannot be assumed that a rental activity conducted by a taxpayer is a business. Before that can be determined, the nature of the rental activity needs to be considered.”

We understand this statement still represents the view of IR. Further IR guidance or public comment would be helpful for taxpayers in assessing this difficult issue.

Conclusion

In our view the application by the TRA in Case 012/11 of the factors used to determine whether or not there was a “business” is highly influenced by the underlying policy of the WfF regime³. This element should not be overlooked in considering the general application of the decision.

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1. From the 2011-12 income year investment losses are no longer taken into account for WfF purposes.

2. “When a taxpayer has a full-time occupation and devotes some of his spare time to stock exchange speculation, one should be slow, I think, to find that he has gone as far as to embark on a business. Usually it would be an artificial use of language. The same applies to a retired or unemployed person who engages in a modest amount of buying and selling shares. In such cases the presumption should be against a business.”

3. The policy being to support families with dependent children, to ensure income adequacy for low and middle income families with dependent children, and to achieve a social assistance system that supports people into work.

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Lindsay Ng, is the Tax Manager at the accounting professional boby NZICA in Wellington. This article was first published here »  and is used with permission.