Mix and match: Mixed use rentals

By Susan Wynne & Conrad Winthrop
 

Are you renting out your beach house this summer, or rented out any residential property this year?  If so, have you got your tax treatment right? 

Inland Revenue has released a draft interpretation statement (the statement) for consultation that outlines the applicable tax rules for taxpayers (other than companies) who derive income from their residential property and what happens when the property use changes.  This guidance provides a useful explanation of the tax deduction rules.  However, the 35 pages needed for this guidance illustrates how complex tax rules have become for residential rental properties.

The statement covers the two sets of income tax deduction rules rental property could fall under; standard tax rules, and mixed-use asset rules and explains how these are triggered.

How do I decide which rules apply to my rental property?

The statement sets out a handy flow chart to follow to determine which rules apply:

This flow chart should be revisited each year to make sure there has been no change to which tax rules apply.

Mixed-use asset rules

The mixed-use asset rules apply when certain assets (including residential rentals properties) are used partly to generate income, partly privately by the owners, as well as when a residential rental property is unused for at least 62 days in an income year. These tax rules are therefore likely to catch most short-term holiday homes that are rented out but also used by the owners privately (or empty for more than 62 days). When a taxpayer has a mixed-use asset, they must apportion expenditure related to the asset between private use and income earning use.

A taxpayer can opt out of the mixed-use asset rules if they made less than $4,000 or a loss is made on the property for the year.  However, once opted out they may no longer claim any tax deductions for expenditure, but any income received from the property will be exempt income and no income tax paid on it.

Standard tax rules

If your rental property is out of scope for the mixed-use asset rules, standard tax rules apply. Income from the residential property is taxable and taxpayers can only deduct expenses that relate solely to the rental activity. Where interest expense is incurred (i.e., on mortgage payments), this may not be fully deductible if the interest limitations apply (until these interest limitation rules are fully phased out from 1 April 2025, for further explanation on the interest limitation rules, see our earlier Tax Alert article).

Note that both sets of tax rules have restrictions on deductions when a residential property has made a loss (called the residential property ring-fencing rules).

Changing between the two tax rules

The statement also explains how the tax rules will apply if there is a change in the use of the residential rental property, for example from mixed-use to full time rental. This starts to get quite complex, as different income tax deduction rules apply in the different scenarios, the restricted deductions under one set of rules may not be accessible under the other.

Where a residential rental property is a mixed-use asset that makes a loss, then the excess expenses may be “quarantined” and carried forward to future income years.

Similarly, under the standard tax rules excess expenses from a residential rental property may be “ring-fenced” and only used against income from other standard tax rule residential rental properties owned by the taxpayer or carried forward to future income years, depending on whether the properties are held in on a “property-by-property basis” or “residential portfolio” basis by the taxpayer.

It is also important to note that mixed-use asset “quarantined” expenditure cannot be used for an asset that falls under the standard tax rules and vice versa for ring-fenced expenditure.

For example, if in 2024 you determine your property falls under the mixed-use asset rules and has quarantined expenditure to carry forward to a future year, and in 2025 you are in a taxpaying position but determine that the property now falls under the standard tax rules, the quarantined expenditure cannot be utilised by this property until it is mixed-use again.

As we said above, the rules get quite complex.

In summary

Although quite detailed, the statement goes through the requirements under the mixed-use and standard use asset rules step by step with examples that clarify how the tax rules should apply. The statement also highlights the complexities of getting these tax rules right. 

For more information on the statement, or how the tax rules apply to your residential rental properties, please contact your usual Deloitte advisor.