If you have bought property as an investment and are not earning enough rental to make a profit, don't expect the taxman to give you a tax break on an ongoing basis.
Many property investments are loss-making ones in their initial years and you shouldn't always expect tax relief for those losses.
The costs associated with property ownership - including the relatively high cost of the interest on the finance used to pay for the property; levies and rates in the case of sectional title property, or rates, insurance and maintenance in the case of freehold property; and management fees paid to managing agents - make the ownership of investment properties for rental purposes an expensive exercise.
As a consequence, in the first few years, the investor often finds it necessary to dig into his or her other sources of income to make up the difference between the rental income and the costs.
SARS relief
So you may ask yourself: does the South African Revenue Service (SARS) recognise that rental losses will be made initially and that the excess costs are being borne out of other income until the rental property becomes viable?
Until March 1, 2004, if you could demonstrate that you had bought the property for the purposes of ultimately deriving a profit, you would have been able to deduct the losses made from rentals against your other income.
To demonstrate that there was the ultimate objective of deriving a profit, it was necessary to establish that a market-related rental was being charged (renting to family might have made this more difficult) and that you had performed some kind of feasibility study showing when you expected to derive a profit, based on expected rental growth, together with projected costs, including interest.
With effect from March 1, 2004 (or the 2005 tax year of an individual), SARS legislated specific rules regarding such losses, in the form of a provisions entitled ''Ring fencing of assessed losses of certain trades".
These provisions cover more than just the rental scenario - they also cover, for example, trading in property (buying and selling).
As far as the rules apply to rental property losses, they apply only in certain situations. Where the ring-fencing rules do not apply to rental properties, the pre-March 1, 2004 situation would continue.
The effect of the ring-fencing provisions is to limit the set-off of rental losses against other income, in certain specified circumstances, or to only allow such losses to be offset against income after the losses have continued for a specified period of time.
Rule applications
The rules apply only if you earn taxable income which is sufficient to pay tax at the maximum marginal tax rate, before taking into account any losses. Thus, for the 2008 tax year, the rules would apply only if you have taxable income of at least R450 000 before the losses (for 2007, it was R400 000), and if, either:
- You have made a rental loss for the year in at least three out of five years, being the current year and previous four years. Since the provisions indicate that SARS may not look at the losses made before March 1, 2004, the 2007 year may be the first year that these provisions kick in, should you have made losses in 2005, 2006 and 2007; or
- The property is residential and 20 percent or more of it has been used by your relatives for half of the year of assessment or more. Relatives, in this case, mean a spouse, parent, child, stepchild, sibling, grandchild or grandparent.
Remember that if you are not allowed to offset the loss you make from renting property against your other income, the loss is not lost altogether for tax purposes. You will need to keep a record of the loss, because when the rental on your property is sufficient to cover the costs to earn you an income, you will be able to set off the loss against that income.
These days, with rising interest rates, and poor rental returns due to a market somewhat flooded with rental properties, you may argue that it is highly likely that you will make a rental loss for more than three years.
So does this mean that, despite the fact that you have used your other income to subsidise your rental business, you have no choice but to accept that you may not offset the loss against that other income?
The answer to this question is no. You may be able to demonstrate to SARS that you have a reasonable prospect of making a profit within a reasonable period, by taking into account the following:
- The amount of income versus the expenses for the current year (the loss may be very small, and you can see that you will make a profit in the next tax year or two);
- The activities you have undertaken to improve the situation; for example, advertising the property.
- The commerciality of the trade (for example, whether you employ people to run your rental business).
- Any unusual circumstances that may have led to the losses continuing in the current year - there may have been significant maintenance that will not be ongoing;
- The existence, and credibility, of your business plan showing that profits will be derived and when;
- The extent to which you or any relative uses the property for personal purposes.
However, SARS may not allow you to continue to deduct the losses even if you have demonstrated these things satisfactorily if, during the last 10 years, including the current year, you have made losses on the rental property for at least six years.
So, next time you are looking to invest in rental property, be aware of these provisions and remember to look at the viability of the investment over a three- to 10-year period.
SARS will not subsidise, by way of a reduction of tax you are liable for on your other income, properties that it does not believe will be viable rental trades.
Even if your income does not exceed the amount subject to the maximum marginal rate, don't think that you will be let off. SARS will still want to consider the viability of the property as representing a trade in order to decide whether to allow you to deduct the expenses relating to the property.
- Deborah Tickle is a tax partner at KPMG