Non-Commercial Loss Rules: When You Can Claim a Business Loss

You have a salary and a side business. The side business made a loss. The obvious move is to offset that loss against your salary and reduce your tax.

Sometimes you can. Often you cannot, and the rules that decide it catch people out because they are checked in an order most articles get backwards. The income test comes first, and if you are above it, the four tests everyone talks about are not available to you at all.

Two Questions, in Order

Before anything else, separate two questions that get run together.

Is this a business at all, or a hobby? If it is a hobby, the non-commercial loss rules never arise. There is no deduction to defer, because there was no deductible loss in the first place. The income is not assessable either.

If it is a business, can the loss be used now? That is what the non-commercial loss rules in Division 35 decide. They do not deny the loss. They decide the year in which you get to use it.

The distinction matters because the two failures look identical on a tax return and are completely different problems. A hobby loss is gone. A deferred business loss is waiting.

First: Is It Actually a Business?

There is no single test. The ATO weighs a set of indicators, and the answer comes from the overall impression:

• Do you intend to make a profit, and is there a realistic prospect of one?
• Is the activity repeated and regular, rather than occasional?
• Is it organised in a businesslike way, with records, a plan, a separate account, an ABN?
• Is the scale and volume commercial, or domestic?
• Is it conducted the way others in that industry conduct theirs?

Selling a few things you made at a market on weekends, with no plan to grow it, is a hobby. The same activity with a costed price list, a supplier account, regular stalls and a target is a business. Nothing about enjoying it changes the answer.

If it is a business, everything below applies. If it is a hobby, stop here, because none of it does.

Second: The $250,000 Gate

This is the step the draft guides tend to bury, and it decides which route you are on.

Work out your income for non-commercial loss purposes. Broadly that is your taxable income ignoring this business loss, plus reportable fringe benefits, plus reportable employer super contributions, plus total net investment losses.

That asymmetry surprises people. A consultant earning $300,000 with a genuinely commercial side business turning over $80,000 cannot use the assessable income test, because the test is not open to them. The loss is deferred and waits for the business to turn a profit.

The Four Tests

If your income is under $250,000, you need to pass one of these for the activity, in the year in question.

1. Assessable income test. The activity produced at least $20,000 of assessable income for the year. Pro-rated if you only carried it on for part of the year. This is income, not profit, so it is the easiest of the four for most genuine small ventures.
2. Profits test. The activity made a tax profit in at least three of the last five years, counting the current year. Useful for an established business having one bad year.
3. Real property test. Real property used in the activity on a continuing basis is worth at least $500,000. Your home and the land adjacent to it do not count.
4. Other assets test. Other assets used in the activity are worth at least $100,000. Cars, motorcycles and similar vehicles are excluded, which removes the obvious shortcut.

Each test applies to the business activity, not to you. Run two separate activities and they are assessed separately, which means one can offset while the other is deferred.

The Exceptions

Two kinds of business sit outside the usual machinery.

Primary production and professional arts businesses are exempt from the deferral rule entirely where your assessable income from other sources, not counting net capital gains, is less than $40,000.

So a working artist, writer, performer or composer with a modest day job can offset losses without touching the four tests. Earn $40,000 or more elsewhere and the exception closes, and you are back to the ordinary rules, including the $250,000 gate.

This is the provision that matters most to the people it covers, and it is regularly missed because it sits outside the main structure.

The Commissioner's Discretion

Where nothing else works, the Commissioner can allow a loss to be used. There are two grounds, and a private ruling is the way to seek it.

Special circumstances outside your control that stopped the activity passing a test. Drought, flood, fire, and similar events. The business would otherwise have passed, and something exceptional intervened.

Lead time. The nature of the activity means it cannot yet pass a test, but there is an objective expectation it will produce a profit or pass one within a period that is commercially viable for that industry. An orchard that takes years to bear, a vineyard, a breeding program.

Note the word objective. Your optimism is not the standard. Independent evidence about how that industry works is, which is why these applications succeed or fail on the material behind them rather than the narrative.

Lead time is not a general excuse for a business that has not worked yet. It is for activities whose economics genuinely require years before the first return, where that timetable is a known feature of the industry rather than a hope.

Deferred, Not Lost

The most common misunderstanding is that a deferred loss is forfeited. It is not.

A deferred loss is carried forward and quarantined against the same or a similar business activity. When that activity makes a profit, the deferred loss is applied against it. If the activity later passes one of the tests, the accumulated losses can be released against your other income.

There is no time limit. A loss deferred in year one can be used in year eight when the business finally turns over $20,000.

Two practical consequences follow. Keep the records: you need to be able to substantiate a loss years after you incurred it, and the paperwork is easiest to assemble at the time. And keep the activity identifiable: losses are quarantined to the activity that generated them, so if you wind one venture up and start a different one, the old losses do not follow you across. Our guide to sole trader deductions covers what belongs in the loss in the first place.

Frequently Asked Questions

Do these rules apply to my company?

No. Division 35 applies to individuals, including individuals in partnership. A company's losses are dealt with under different rules, with their own continuity of ownership and same business tests. If you are choosing a structure partly for this reason, our guide to business structures is the place to start.

What if I have two side businesses?

Each activity is tested on its own. One may pass and offset while the other is deferred. Keeping their records genuinely separate is what makes that possible.

I made a loss in my first year. Is that a problem?

Not by itself. A first-year loss is ordinary. The question is whether you pass a test this year, and if not, whether the loss is simply deferred until you do. Plenty of businesses run deferred losses for their first few years and use them later.

Does the $20,000 include GST?

No. Assessable income is measured excluding GST if you are registered.

Can I choose which test to apply?

You need to satisfy only one, so in practice you use whichever you meet. You do have to be able to demonstrate it, so if you are relying on an asset value test, have a defensible valuation rather than an estimate.

How do I ask for the Commissioner's discretion?

By applying for a private ruling, ideally before you lodge, with evidence supporting either the special circumstances or the commercially viable period for your industry. It is worth getting help with, because the application is largely decided by the quality of what is attached to it.

---

The non-commercial loss rules are less about whether your business is real and more about the order the questions get asked in. Hobby or business. Under or over $250,000. Then, and only then, the four tests.

Trew North Accounting works with Melbourne sole traders and side businesses on exactly this. See our accounting and tax planning and small business accounting services, or get in touch.

This article is general information, not advice for your circumstances. Thresholds and rules change. Check current requirements with the ATO or with us before you lodge.