Do landlords (and their tax agents) lead in tax evasion and cheating?
The residential rental property sector is plagued by heavy and persistent non-compliance when it comes to tax deductions, writes UNSW Business School's Dale Boccabella
In his recent speech to The Tax Institute’s Tax Summit (20 October 2022), 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 broadly 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. The estimate of the tax gap for 2018-19, a recent year of available figures, is roughly $33 billion (or 7 per cent of the proper tax collection). The biggest contributor to the gap was the small business sector ($12 billion of the $33 billion tax gap).
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 from an ATO program (the random enquiry program) into the sector suggested that 9 out of 10 tax returns reporting net rental income required adjustment. He went on to say that this is startling and clearly something we need to address.
Two points should be noted from the random enquiry program dealing with individuals not in business (which includes residential rental property owners). First, both tax agent-prepared returns (80 per cent) and taxpayer-prepared returns (61 per cent) required adjustment. Secondly, some adjustments (around 10 per cent) resulted in less tax payable.
Regrettably, the poor compliance rate has been the position for this sector for many years as evidenced by the raw numbers and the regular targeting of ATO audit activity in the sector. That is, there is persistent and entrenched non-compliance (in truth for many situations, tax cheating or tax evasion). It includes not declaring rental income, not declaring the capital gain on the sale of the property, claiming the main residence exemption under the capital gains tax (CGT) for the profit on the sale of a rental property, claiming interest deductions when a property is not truly available for rental (e.g. holiday homes), claiming capital expenditure as an immediate deduction, declaring all rental income and claiming all deductions to one spouse when the loss-making property is co-owned and claiming deductions for the full cost of travel to a property when the travel was partly for private purposes (e.g. holiday).
It got so bad that in some expenditure areas, even the government and the parliament “threw its hands in the air” as if to say, enough is enough. In and around 2017 to 2019, the 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 transactions in this sector. A third denial rule (s 26-102) was also in part targeted at, or operated in, this sector.
How deduction denial rule laws work
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. The denied deductions may now give rise to a capital loss under the capital gains tax regime. Such use of an asset can occur by taking a private asset from one’s home (e.g. stove) and placing it into a rental property or by the purchase of a rental property (with used assets in it). Before the enactment of s 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. 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.
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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. This was not how the tax law operates (operated) when a second-hand asset, previously used for private use for example, is put to use in an income activity. The same point applies to the 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 among the total single price paid for the rental property. In short, the resulting depreciation deductions claimed by the taxpayer was much greater than the law allowed.
Section 26-31 denies deductions for travel to and from a rental property (e.g. to inspect the property, and arrange a repair). Under the old rule, there can be difficulties in determining the correct deduction amount (portion) where the travel had two purposes or aims, for example, to take a holiday and visit or 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. Again, improving the integrity of the tax system was mentioned among the official reasons for s 26-31.
Section 26-102 denies deductions for revenue expenses (most significant being interest on a 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 s 26-102, 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 s 26-102 can be included in the cost base of the land for CGT purposes. Some taxpayers were claiming deductions when the land and property were not genuinely held for producing assessable income (no intent to rent or it was a “distant dream”) was mentioned as the justification for s 26-102.
Cracking down on non-compliance
There are many provisions denying deductions in our tax law where the expense would otherwise be available because of the link to an income activity. However, I cannot recall any other instance under the income tax where a deduction denial provision is enacted for certain expenditure otherwise deductible solely on the basis that the taxpayer grouping involved will not comply with the tax law and the ATO cannot attain sufficient compliance. This is clearly the case with s 40-27. There is (was) no or at least minimal grey area here and any registered tax agent should be capable of getting this right, sometimes perhaps with a little basic research. Subject to one near irrelevant qualification, the same applies to s 26-31. That qualification is that it can be difficult to get a high degree of precision in apportionment of expenses where dual-purpose travel is involved, but 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 s 26-102.
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.
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One does not want to be too critical of the ATO because it is a highly respected regulatory agency and arguably, under-resourced, but one can legitimately ask how the ATO can be so ineffective over such a long time in detecting and correcting non-compliance in this taxpayer grouping. There may be factors about this grouping 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.
On application of the [correct] tax law, natural person investors in residential property face a generous tax regime, mainly in the form of negative gearing and the 50 per cent capital gains tax discount.
The answer to the question in the title requires the selection of applicable comparative criteria and a comparative analysis on such things as the overall amount of lost revenue, is the non-compliance (cheating) mainly tax agent-driven or taxpayer-driven and a number of taxpayers in the grouping 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 this sector, as a collective, is competing hard to be leading this anti-social activity.
Dale Boccabella is an Associate Professor in the School of Accounting, Auditing and Taxation at UNSW Business School. For more information please contact A/Prof. Boccabella directly. A version of this article first appeared on The Conversation.