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Mixed-use properties and tax inconsistencies

As our urban environments change, so do the buildings and structures in which we work and live. In recent years we have seen "mixed use" buildings change in nature, and correspondingly in their tax treatment. 

More and more we are seeing properties that comprise a mixture of residential and commercial space (e.g. residential apartments over retail and/or office space etc) which also fall under the category of mixed-use buildings. With these types of mixed-use buildings becoming increasingly popular and various legislative changes over the last couple of years, some inconsistencies in the tax treatment of these buildings for GST and income tax purposes has been apparent.

For GST purposes, it has long been established that where a property is used for a mixture of residential accommodation and other purposes (e.g. commercial rental), an apportionment is required to determine the amount of taxable versus exempt supplies. This apportionment is generally based on floor area.

When the new rules providing for the ring fencing of residential rental losses and the reintroduction of depreciation on commercial buildings were announced, it was reasonable to assume that a similar basis of apportionment would apply in relation to these rules. However, this does not appear to be the case.

 

Ring-fencing of residential rental losses

The application of the ring-fencing rules turns on there being a ‘residential rental property’ which is a defined term that, in turn, relies on there being ‘residential land’. That term is defined to mean, amongst other things, ‘land that has a dwelling on it’.

A dwelling in the context of the Income Tax Act 2007 means ‘any place used predominantly as a place of residence or abode, including any appurtenances belonging to or enjoyed with the place’ [emphasis added].

Based on the predominant use aspect of the dwelling definition for income tax purposes, the categorisation of the predominant use (more than 50%) of a property into either commercial or residential, will be crucial to how income is returned. On the basis that the application of the ring-fencing rules is dependent on the property being predominantly used as a place of residence or abode, where a property is used predominantly (more than 50%) for commercial rental, there would seem to be no restriction on the use of any losses arising, even if, were a similar basis of apportionment applied as between the residential and commercial activities, to that required for GST purposes, those losses could be ascribed to the residential rental activities within the property.

 

Depreciation on buildings

The reintroduction of an ability to claim depreciation on buildings (effective from 1 April 2020) does not extend to a ‘residential building’. The residential building definition is also driven largely from the definition of a dwelling and it too points toward the predominant use of the building being determinative as to whether depreciation can be claimed or not.

Conversely a ‘commercial building’ means ‘a building that is not, in part or in whole, a dwelling, unless use as a dwelling is a secondary and minor use’.

The words ‘and minor use’ in the commercial building definition gives rise to some ambiguity as to the extent to which a commercial building can include dwellings, yet still be categorised as a commercial building.

 

Inland Revenue view

Our enquires with Inland Revenue, as to whether and to what extent, apportionment should apply between the residential and commercial activities within a mixed-use building, for income tax purposes, resulted in a high level response which indicated that the ‘predominant use’ test should indeed be applied in such circumstances. In short, in contrast to the apportionment of a mixed-use building between residential and commercial, for the purposes of calculating GST, it would appear that an all or nothing approach seems to be the preferred basis of determining the status of the building for income tax purposes. It is noted however, that the response received from Inland Revenue was somewhat informal and would clearly not bind Inland Revenue as to its approach to mixed-use buildings.

 

Practicalities of ‘predominant use’ approach

With buildings increasingly comprising a mixture of residential and commercial space and the difficulties of ascribing building fit-out such as air conditioning, fire-safety services and common use assets, to one or the other of those uses, the predominant use test is perhaps something which is to be welcomed as a means of simplifying taxpayer compliance costs.

It is probably correct that the rules around the ring-fencing of residential rental deductions, which were arguably introduced to dissuade private investment into single dwelling residential housing (as a means of assisting first-home buyers), should not apply to buildings which have a significant commercial component.

The issue is where to draw the line on when such buildings will be seen, for income tax purposes, as no longer qualifying under the rules applying to most other forms of business investment.

Further, if it is accepted that a predominant use test is the correct way to approach mixed-use buildings from an income tax perspective, perhaps the legislators should look to consistency, so that only direct costs associated with residential rental activities (which constitutes an exempt supply in respect of which GST input tax credits are unable to be recovered), are precluded from being able to be claimed, when determining a commercial operator’s GST liability.

Another possible option, where a predominantly commercial landlord earns income from residential rental, may be to require the landlord to account for GST on their residential income (as if it were not an exempt supply) therefore precluding any need for apportionment for GST purposes.

The complexity around GST apportionment has been recognised as an issue by Inland Revenue in their GST policy issues paper (released in 2020). It is hoped that in addressing this complexity, consistency with income tax will also be borne in mind.

Risk mitigation

Given the apparent inconsistencies between income tax and GST, there is a risk that Inland Revenue may take differing views on income tax and GST claims, depending on the specific circumstances associated with a mixed-use building. If you have a mixed-use building, we recommend discussing your options, including ways of mitigating any risk, with your usual Baker Tilly Staples Rodway advisor.

DISCLAIMER No liability is assumed by Baker Tilly Staples Rodway for any losses suffered by any person relying directly or indirectly upon any article within this website. It is recommended that you consult your advisor before acting on this information.

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