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Question: Residential ring-fencing rules when there is a change in use?
An individual owns a residential rental property that has been rented out for several years. During the 2020 tax year, the tenants moved out and the individual moved in. For the rest of the year the property was the individual's main home.
What happens when a residential property changes use from a rental property to an owner-occupied property?
- Do the losses generated up to the point of change in use remain ring fenced until the property is sold?
- Can the losses in the year of transition be claimed if the main home exclusion in s EL 9 is met?
What does "most" in s EL 9 mean? More than 6 months? More than 8 months?
The residential ring-fencing rules apply for an income year when a person is allowed a deduction for expenditure or loss incurred in relation to one or more residential rental properties.
The extent to which the person's deduction is more than their residential income, the excess amount is:
- suspended as a deduction for the income year;
- carried forward to a later income year in which the person derives residential income; and
- added to the amount of the deduction for expenditure or loss for the later income year.
A "residential rental property":
- means residential land for which a person who owns the land is allowed a deduction relating to the use or disposal of the land; and
- includes land that, for a time in an income year, is residential land.
The ring-fencing rule does not apply if more than 50% of the land is used, for most of the income year, by the person as their main home. "Main home" means the one dwelling that is mainly used as a residence by the person, and — if a person has more than one home — the one dwelling with which the person has the greatest connection.
When a person disposes of property (regardless of whether or not it is residential rental property for the person at the time of the disposal) and has unused excess deductions relating to the property, those excess deductions are released if the person has taxable income under the land sales provisions as a result of the sale.
By contrast, when a property changes its use from residential rental to a main home, any excess deductions are not released from the ring-fence. The release of the excess deductions occurs only when the eventual sale of the property triggers taxable income. If the eventual sale does not trigger taxable income, the excess deductions continue to be carried forward until the individual has sufficient residential income.
If a residential rental property becomes a person's main home during an income year, the associated rental deductions are not subject to the ring-fencing rules for that year. If the property is used for most of the income year as the individual's main home, the ring-fencing rules will not apply to deductions incurred during the part of the year in which the property was a rental property. The loss for that part-year will be available for offsetting against non-residential income.
While there is no guidance from Inland Revenue on what is meant by "most" in section EL 9, based on how this is interpreted in other contexts it would mean the property was the person’s main home for more than half the year.
Income Tax Act 2007, ss EL 3, EL 4, EL 7, YA 1 ("main home").
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