Prior tax losses can help you meet NCL rules

Media Release - Friday January 9

Key Insights:

Carried-forward revenue losses reduce taxable income and can be critical in keeping adjusted taxable income below the $250,000 threshold for non-commercial loss purposes.

Revenue losses carried forward from prior years are distinct from deferred non-commercial losses and are allowable deductions when calculating adjusted taxable income.

Misunderstanding how adjusted taxable income is calculated can lead to business losses being incorrectly deferred under Australia’s non-commercial loss rules.

The Non-Commercial Loss (NCL) rules have been a thorn in the side for individuals conducting a business, alone or in partnership, since their inception in 2000.

If you fail to meet these tests, any tax loss on your activities is deferred and carried forward until the tests are met in a subsequent tax year (if ever), even where your activity meets the criteria of an income tax ‘business’. This is a real frustration to taxpayers wanting to get immediate tax relief for the losses they derive in the early years of their activity.

We deal regularly with these rules at Baumgartners given the amount of horse breeders we act for, by virtue of their activities often taking beyond three years to derive a profit.

Fellow tax advisers, who don’t regularly deal with these rules, often misunderstand how they operate. This article will comment on one of the common ‘problem’ areas I often must clarify them on, i.e. how to determine what is ‘Adjusted Taxable Income’ (ATI). More specifically, how do carry-forward revenue losses impact on this calculation.

Overview

The NCL rules, found at Division 35 of the ITAA 1997, prevents losses from a non-commercial business activity carried out by an individual taxpayer (alone or in partnership) from being offset against other assessable income in the year in which the loss is incurred, unless an exception applies.

Losses that cannot be offset against other income in the year in which they arise (i.e. quarantined losses) may be carried forward to be offset in a future year when there is a profit from the non-commercial activity or against other income, if a relevant exception from Div 35 is available.

When NCL loss deferral does not apply

The NCL rules apply to defer a deduction for an individual’s losses, unless an exception applies. The exceptions to the rules are:

(1) the individual meets at least one of four tests that apply to the relevant business activity and, for 2009–10 and later income years, the taxpayer’s ‘adjusted taxable income’ does not exceed a threshold, currently $250,000 (see below)

if the exception described in (1) is not available, the ATO may, if asked, exercise discretion not to apply the loss deferral rule if its application would be unreasonable. To demonstrate the unreasonable application of these rules, the taxpayer is required to submit a detailed Private Ruling request in the appropriate form

the individual is carrying on a primary production business or a professional arts business and the income from other sources (excluding net capital gains) is less than $40,000.

the NCL rules do not apply if the individual’s activities do not constitute a business (e.g., the activity is a hobby, or the income is from passive investments such as rent from negatively geared property or dividends from shares, or where a business has ceased).

Exception (1): tests for deductibility

An individual can only deduct a loss from a non-commercial activity if they meet at least one of four tests. From the 2009–10 income year, they must meet an income threshold test as well as passing one of the 4 tests. Under the income threshold test, if the individual’s “adjusted taxable income” is $250,000 or more for the year, exception (1) does not apply and any loss from non-commercial activities is quarantined. The four tests are:

• assessable income test — the assessable income (including capital gains) for that year from the activity must be at least $20,000

• profits test — the particular activity must have resulted in taxable income in at least 3 out of the last 5 income years, including the current year

• real property test — the total reduced cost bases of real property or interests in real property used on a continuing basis in carrying on the activity must be at least $500,000, or

• other assets test — the total value of other assets (other than motor vehicles) used on a continuing basis in the activity must be at least $100,000. Note that, for the purposes of trading stock, ‘value” refers to ‘tax value’ at year end.

What is ‘adjusted taxable income’ (ATI)?

As noted in my introduction, the ATI definition is too often misunderstood by tax practitioners and its central to the application of the NCL rules.

An individual passes the income threshold test for an income year if the sum of the following, referred to as ‘Adjusted Taxable Income’, is less than $250,000:

(a) their taxable income

(b) their reportable fringe benefits total for the year

(d) their total net investment loss for the income year (e.g. net loss on share investments, rental loss etc)

disregarding the individual’s assessable FHSS released amount (relating to

Superannuation withdrawals) for the income year.

Are carried-forward revenue losses part of taxable income?

As noted above, ‘taxable income’ is one of the ATI components and easily the most important.

Per the Tax Act, ‘Taxable Income’ is defined as:

“your assessable income minus any allowable deductions.”

Your taxable income is used to work out how much tax you need to pay. For the avoidance of doubt:

Assessable income − allowable deductions = taxable income

The problem area I often find is that tax losses derived and carried-forward from a prior year, are overlooked as an “allowable deduction” for the purpose of the taxable income definition. This can be a crucial mistake. For example, such tax losses, referred to as “revenue losses”, are incurred where the sum of your allowable deductions exceed your assessable income in the prior tax year.

To be clear, do not confuse a “revenue loss” with the above mentioned “deferred loss” concept, a “deferred loss” being incurred where your business loss meets none of the NCL tests and must carried forward under those rules only.

In addition to the Tax Act, there is an ATO private ruling, issued in October 2015 and referred to as number “1012896499113” where it directly confirms that carried-forward revenue losses do form part of ‘taxable income” for the purposes of applying the NCL rules.

Applying a carried-forward revenue loss can thus make it a lot easier to meet the NCL tests as your adjusted taxable income will often land below $250,000 when these are taken into account in calculating taxable income. Consider this example:

Example – using carried-forward revenue losses to keep ATI under $250,000

Glenn runs a horse breeding taxation business that incurred a taxation loss of $150,000 in the 2025 tax year. Sales for 2025 was $30,000, lower than normal due to a virus that swept through his property.

Glenn must meet the NCL tests to be able to claim these losses against his other income in 2025.

His other income and deductions in 2025 were:

Wages - $300,000
Loss on rental property – $60,000
Work related deductions - $15,000
Carried forward revenue loss from 2024 - $40,000

His ATI for 2025 is calculated as follows:

$300,000 wages less $15,000 work related deductions less $40,000 carried forward revenue losses = $245,000. As this ATI is under $250,000, Glenn need only meet one of the four tests to claim his $150,000 horse loss.

His sales turnover was $30,000; thus he can do so as this was at least $20,000 per the above mentioned “assessable income” test.

The feature of this calculation is that the $40,000 carried forward revenue loss is allowed, however the net rental loss of $60,000 is not allowed as its amount is added back for ATI purposes (originally it was part of taxable income). If not for taking account of these revenue losses, his advisor would have incorrectly assessed his entitlement to the $150,000 loss applying the more onerous and costly “$250,000 plus” test, where a successful private ruling application would be required to deduct the $150,000 loss.

Pease do not hesitate to contact the writer if you wish for me to clarify or expand on any of the matters raised in this article

PAUL CARRAZZO CA, CPA

Partner - Baumgartners