Tax Deductibility of Holding Costs Associated with Vacant Land

Vacant Land and the Land Component of Residential Rental Properties

When Can an Income Tax Deduction be Claimed for Holding Costs?

Since 1 July 2019, holding costs in relation to vacant land and land acquired for the construction of residential rental properties that are untenanted at the time the costs are incurred, have been limited by the operation of s26-102 of the Income Tax Assessment Act 1997 (ITAA 1997).

This does not just relate to land purchased after this date, but for all holding costs incurred from this date, even where the land was acquired previously.

Put simply, an income tax deduction that would normally be available under the general deductibility provision of s8-1 of ITAA1997 will be denied where the vacant land that the holding costs relate to has no substantial or permanent structure in use, or available for use, at the time the loss or outgoing is incurred, unless the property is being used, or available for use, in carrying on a business to gain assessable income.

Section 26-102 does not generally apply to property developers, as they are carrying on a business. Vacant land held for future development in the property development business would also qualify, as it is ‘available for use’, but this concession only applies where the land is held by the same entity that operates the property development business.

The substantial or permanent structure must also be independent of, and not be incidental to, the purpose of any another structure on the land. An example of an incidental structure may be a boundary fence on a residential rental property, whose purpose is not independent of the rental premises. Contrast this with a paddock or boundary fence on a primary production property, that has a purpose independent of any other structures on the farm.

Similarly, for residential properties, no income tax deduction is available for the holdings costs associated with the land (interest, borrowing costs, rates, insurance, land tax etc) unless the residential premises constructed, or substantially renovated, are lawfully able to be occupied (if uncertain, where a certificate of occupancy or similar is received from the local council) and leased, hired or licensed, or genuinely available for lease, hire or licence.

Small periods of time between when a property is tenanted, where repairs may be undertaken for example, would not generally impact the deduction for the land holding costs associated with the property.

Where there has been a separate loan for the acquisition of the land and the subsequent construction of the residential premises, s26-102 does not limit the deductions available in relation to the construction loan, only the land loan.

Where a deduction is denied for the holding costs incurred in relation to vacant land or untenanted residential rental properties, these costs will be capitalized and form part of the third element of the cost base of the asset, assisting to reduce the eventual capital gain on disposal.

Who do these provisions apply to?

These provisions apply to individuals, partnerships where an individual is one of the partners, discretionary trusts, unit trusts where any of the unit holders are individuals and self managed superannuation funds (SMSF’s).

There are a number of exemptions to these general rules:

1. Land is used in carrying on a business, or leased to an entity carrying on a business

 For a landholder to be able to claim a deduction, the business may be carried on by:

• you, your spouse and/or children under 18;
• your affiliate, or any entity that you are affiliated to;
• an entity connected with you.

There are separate timing provisions where the business has ceased at the time the loss or outgoing was incurred, or other circumstances where the loss or outgoing was incurred at an earlier time when the business was being carried on.

2. Type of entity exemption

The following entities can claim deductions under this section:

• companies,
• superannuation funds (excluding SMSF’s),
• managed investment trusts,
• public unit trusts and
• unit trusts or partnerships where all of the members at the time the land was vacant are listed above from a. to d.

3. Structures impacted by natural disasters or other exceptional circumstances

If there was previously a substantial or permanent structure on the land and a natural disaster or exceptional circumstance beyond your control occurred so that you would no longer be able to claim losses or outgoings under this section, you can continue to claim these deductions for up to three (3) years from the date of the event. Note, you need to keep written records of the event for five (5) years  after you have claimed the deduction under this exemption.

4. Primary Producers

Deductions for the loss or outgoing may be claimed where:

• The land is leased to an entity carrying on the business of primary production;
• There are no residential premises on the land (and residential premises aren’t being constructed).

5. Land leased to a third party

Deductions for the loss or outgoing may be claimed where:

• Where the land leased to a third party on arm’s length terms and it is in use, or available for use, in carrying on a business; and
• There are no residential premises on the land (and residential premises aren’t being constructed).

Where only part of the land is used in a business or meets the requirement for an exemption, holding costs will need to be apportioned and a deduction will be available for the business/exempt portion of the land.

The ATO has recently released TR 2023/3, which provides examples of where a deduction may, or may not, be claimed for a loss or outgoing under s26-102. Some common examples include:

      Vacant land, fenced with a garden shed – residential rental property yet to be constructed:

No deduction is available for the holding costs associated with this land, as the garden shed is unable to be occupied as residential rental premises

      Residential property is tenanted, but the tenants leave as the owner intends to demolish the house and construct two townhouses

Deduction is available while the house is tenanted or available to be tenanted. If the property is unfit/unable to be tenanted, no deduction is available for the holding costs from that date.

      New residential rental premises are constructed on vacant land

After construction has been completed and the occupancy certificate is received, the owner lists the property with a local real estate agent – land holding costs are deductible from the date the property is listed with the real estate agent, as it is ‘available for rent’ from this time.

The ‘mischief’ this section is trying to address is where taxpayers previously claimed significant income tax deductions for interest and borrowing costs prior to the vacant land becoming income producing.

The limitation on the deductibility of holding costs associated with vacant land, and the land component of constructed residential rental properties, may significantly impact the decisions by individuals, individual partners or discretionary trusts to acquire vacant land to construct residential rental premises, compared with financing the purchase of a property that has already been completed.

Where the tax deduction is necessary to support the business case for this activity, especially in a time of increasing interest rates, for some taxpayers the decision not to proceed down this path at this time may be prudent.

Michelle Wilson

29 September 2023