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10 Legal Service Bull. 234 (1985)
Attacking the Highly Geared Rental Property Loophole

handle is hein.journals/alterlj10 and id is 244 raw text is: TAXATION REFORM any attempt to bring a matter before a higher court, to interpret provisions of the Act in whichever way it con- siders most advantageous to its own policies and inter- ests and to behave unfairly and, at times, unlawfully. It clearly does not consider itself generally bound by the ratio decidendi in AAT decisions, as demonstrated by both the Galati case and the Spooner case, nor by the words of ministers in Parliament when new provis- ions are introduced or amendments made to earlier pro- visions. The independence with which DSS is permitted to operate brings it at times perilously close to being beyond the control of either Parliament or the judiciary. Law reform and property interests Attacking the highly geared rental property loophole Richard Krever In mid-July 1985, the Treasurer of Australia announced the end of a widespread income tax loophole that had been exploited by thousands of high bracket taxpayers to avoid taxation on substantial amounts of income. The loophole in question was available to taxpayers investing in 'highly geared' rental properties, i.e. investments in which interest payments on borrowed funds used to acquire the investment exceeded rental income generated by the property. The subsequent reaction of the tax avoidance industry and the lack of effective response by the Government to the arguments raised by tax avoidance planners highlight the risk that tax law reformers may win the occasional battle only to lose the war if their tactics and responses do not mature quickly. THE LOOPHOLE The tax subsidy for investments in highly geared rental properties arose when taxpayers discovered they could mismatch expenses and gains for tax purposes. These taxpayers owned rental investments which, at first glance, appeared to be losing propositions - rental receipts never equalled interest payments on the loan taken out to purchase the properties. But expenses did not exceed total revenue; they merely exceeded taxable gains. Much, or in some cases most, of the return on the property came in the form of capital appreciation - that is untaxed capital gains realised when the property was subsequently sold. Highly geared rental property schemes were profitable because an inadequately drafted deduction section in the Income Tax Assessment Act 1936 combined with a narrow, literal interpretation of the provision to allow taxpayers a deduction for all their interest expenses even though only a portion of those expenses was in- curred to earn taxable income. Income tax principles re- quire taxpayers to match expenses with gains and this is what the deduction section was intended to accomplish. To the extent interest payments resulted in taxable rental payments, they should be deducted from the rent. Excess interest payments, incurred to earn capital gains and not rent, should be matched to the capital gains. And because capital gains are exempt from taxation, the expenses incurred to earn them should not be deductible for tax purposes. But it was possible to read the deduction provision in a literal fashion that defeated the policy of the section and, indeed, the Act, by allowing taxpayers to deduct all interest payments, even those incurred to earn exempt capital gains. Not surprisingly perhaps, this was the inter- pretation adopted by the Barwick High Court and not since reversed. Taxpayers were thus able to shelter other income (such as salaries or share dividends) from taxa- tion by using interest payments that exceeded their tax. able rental receipts to offset that other income. With prudent planning, high bracket taxpayers found it was possible to eliminate a sizeable portion of income in the tax world without incurring any losses in the real world. After years of inaction, the Government finally moved against the abuse, albeit in a somewhat restrained manner. The proposals announced by the Treasurer in mid-July do not affect highly geared transactions entered into prior to that date so all taxpayers presently enjoy. ing the avoidance benefits of the schemes are insulated from the new law. Taxpayers making highly geared prop- erty investments after that date are only able to deduct interest expenses against rental income. Excess expenses for which no deduction is currently allowed may be car- ried forward indefinitely and deducted from future rental income in any year rents exceed interest expenses. Alternatively, unused excess interest expenses can be deducted from income resulting from the sale of the property if that is taxable. THE DEFENCE Lawyers for taxpayers who used the negative gearing system argued against reform and elimination of the loophole on two grounds. First, they claimed that reform would impose an unfair burden on persons who had made investments on the basis of existing law. Second, they asserted that the loophole provided indirect assistance to low income renters and its elimination would cause hardship on a segment of the community least able to afford it. It is not difficult to meet and overcome both asser- tions. Indeed, one might argue that the Government had Legal Service Bulletin

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