By Barry Ger*
Every person who buys a rental property as an investment hopes to make a profit but that doesn’t always happen. Often, the rental your tenant pays doesn’t cover the interest on the bond you took out to finance the property, the fees paid to the management agent, the levies or rates, as well as the myriad other costs associated with property ownership. So sometimes you take a loss in your first year as a landlord. In fact, sometimes you’ll make losses in your first several years.
“Chin up,” you may say to yourself. “It’s not the end of the world. There’s a silver lining. At least, this means I get a tax break.” You’d be thinking here of the accepted wisdom that SARS lets you offset a loss you make on one investment against income you earn from other endeavors resulting in you having less income to tax. Even if your losses are greater than the income you make in the one year, you are permitted to “carry forward” these losses into the next year and you get a tax break there then as well.
Unfortunately, it doesn’t necessarily work that way.
Running “ring-fences” around rental losses
Since 1 March 2004, losses individuals make from renting out their property are subject to the so-called “ring-fencing” rules in the Income Tax Act.
The name of these rules gives a clue as to how they work. Imagine if you and your partner were surrounded by a very high and imposing chain link fence that separated you from all your neighbors – Trapped in this way, you’d only get to interact with your partner inside the fence, wouldn’t you?
Well, in the same way, these rules allow SARS to limit or “ring-fence” losses you make from leasing property to the rentals you make from this particular trade. Thus, the losses you make on your property-renting business can only be set off against the rentals you make for tax purposes and no part of them can “jump” the fence to be set-off against income from other trades you may engage in, such as, for example, your regular salary.
Circumstances under which ring-fencing applies
Still it’s not all bad news. These ring-fencing rules fortunately only apply in specific circumstances.
Firstly, you must be a top earner (ie someone who SARS hits with the maximum tax rate of 45% ). In your 2019 tax year, this means you must have earned at least R1,500,000 (before taking into account any losses).
Secondly, you must have made a rental loss in at least 3 out of the past 5 years, with one loss in the current year and losses in 2 of the previous four years. That means that the provisions will kick in for 2019 if you have had 2 other years of rental losses in 2018, 2017, 2016 and/or 2015.
Even if both these circumstances apply, the Income Tax Act provides that your rental losses may not be “ring-fenced” if you can prove to SARS that you have a “reasonable prospect” of making a profit “within a reasonable period” taking into account your specific facts and circumstances such as :
· The amount of rental versus the expenses for the current year (ie SARS will look more favourably at you if you have high rental and higher expenses rather than low rentals and high expenses);
· The things you have done 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 (eg non-paying tenants, earthquakes etc);
· Whether you have a business plan and how believable it is;
· The extent to which you or any relative uses the property for private use
These provisions are known collectively as the “escape clause” because they allow your loss to “escape” the confines of the ringed fence so as to reduce your other taxable income.
A word of warning though on “suspect trades”
A word of warning though. SARS will treat you more harshly if your rental business is what they classify as a “suspect trade”. This would happen if your rental “business” comprises leasing residential accommodation to your relatives who
a)take up more than 20% of the floorspace in the properties and
b)have been there for at least half the year.
If this is your “business”, then that 3 out of 5 year rule I mention above, won’t apply. SARS will “ringfence” any loss immediately in the year in which it occurs.
You might still be able to use the “escape clause” provisions I set out above but even they won’t help you if you have made losses for 6 years or more over a 10 year period.
If all this sounds complicated, SARS kindly provides a handy flowchart at the link below to guide you through:
Don’t let any of this stop you from becoming a landlord though. The takeaway is that you still get tax breaks from renting out property but SARS will prevent you from enjoying these if it thinks you are not serious about ultimately making a profit.
*Barry Ger is a Senior Manager at KPMG in South Africa. He provides international and corporate tax advice to KPMG’s Cape Town clients. He is an Admitted Attorney as well as a Registered Tax Practitioner. He has an Honours degree in Taxation from the University of Cape Town as well as an Advanced Diploma in International Taxation from the Charted Institute of Tax Practitioners in the United Kingdom.