Non-Commercial Losses: Can You Offset Your Business Loss Against Your Salary?

Welcome to the podcast, our newsletter made easy. Please note, this podcast features AI-generated voices for your hosts, Mia Taylor and Leo Baker, bringing you expert insights from owner Ben De Rosa at Aevum Accounting. Each week, we're here to help you confidently navigate the ins and outs of Australian tax. Whether it's for your individual finances or the complexities of your business. We'll cut through the jargon to give you strategies for compliance, smart planning, and that ultimate peace of mind. So if you're looking to understand your obligations, maximize your financial position, or simply gain clarity on your money matters, you're in the right place. Let's get started with our review of the week. This week's review comes from Side Hustle Sarah in Joondalup. She writes, "I started a small candle-making business last year. I spent $5,000 on wax and jars but only sold $500 worth of candles. I thought I could claim the $4,500 loss against my nurse's salary to get a big refund. Ben told me about non-commercial losses and saved me from a massive headache. Thanks for keeping it real." Sarah, you have stumbled upon one of the most misunderstood areas of tax law, and you are definitely not alone. A lot of people think, if I lose money on my side hustle, the ATO will help subsidize it by reducing the tax on my main salary. But the ATO has a specific set of rules to stop exactly that. They are called the non-commercial loss rules. Basically, the ATO doesn't want to fund your hobbies. If you are running a business that consistently loses money, they don't want you offsetting those losses against your wages unless you can prove it's a real commercial enterprise. So today, we are going to break down exactly how these rules work. We'll cover the income requirement, the four tests, and what happens if you don't pass them. But before we even get to the loss rules, there is a pre-game check we need to do. Is Sarah even in business? Great point. This is the hobby versus business test. If Sarah is just making candles for fun, giving them to friends, and selling a few at a market to cover costs, she isn't in business. She is a hobbyist. And what are the tax rules for hobbies? Hobby rules: you don't declare the income, but you can't claim the expenses. So if she spent $5,000 and made $500, she just lost $4,500 of her own money. The ATO is not involved at all; no tax return entry required. But Sarah wants to be a business. She wants that deduction. How does the ATO decide if she is commercial? They look for the badges of trade. Is there a genuine intention to make a profit? Is there repetition and regularity—is she selling every week or just once a year? Is it organized like a business—does she have a business bank account, a website, records? Is the size and scale significant? Okay, let's assume Sarah is a business. She has an ABN, a website, and she is trying to make money. She spent $5,000, she earned $500, she has a $4,500 loss. Now we hit the non-commercial loss rules. These rules act like a gatekeeper. They say, "Stop, you cannot use this $4,500 loss against your nurse salary unless you pass our tests." If she fails the test, does the loss disappear forever? No, it gets deferred. It sits in a special bucket and rolls over to next year. You can only use it to offset profits from that specific business in the future. So Sarah has to wait until the candle business itself makes a profit before she can unlock those losses. Okay, so how do we pass the test? There are two hurdles. Hurdle number one is the income requirement. This is the big one for high income earners. To even look at the other tests, your adjusted taxable income must be less than $250,000. What counts as adjusted taxable income? It's basically everything: your salary, your rental income, reportable fringe benefits, reportable super contributions, and total net investment losses. If that number is $250,000 or more, you are immediately blocked. You cannot offset your business loss against your salary, period. The ATO basically says you earn enough money, you don't need a tax break for your side project. So if Sarah was a surgeon earning $300,000, she's out of luck immediately? Correct. Her losses are automatically deferred. She can only claim them when the candle business itself makes a profit. But Sarah is a nurse, so let's assume she earns $90,000. She passes the income requirement—less than $250,000. Now she faces hurdle number two: the four tests. Correct. To offset the loss this year, she only needs to pass one of these four tests. Test one: the assessable income test. This is the most common one. To pass this, your business must have generated at least $20,000 in assessable income—revenue—in the financial year. Note, this is revenue, not profit. So Sarah sold $500 of candles. Did she pass? No, $500 is less than $20,000. Fail. But here is a strategy: grouping. If Sarah also had a soap-making business that made $19,500, she could potentially group the candle and soap activities together as "handmade crafts." Total revenue $20,000. Result: pass. That is a pro tip, group similar activities. Okay, test two: the profits test. This test looks at your history. Your business must have made a tax profit in three out of the past five years, including the current year. Since Sarah just started and made a loss in year one, she fails this test too. Test three: the real property test. This is for businesses that use land or buildings. To pass, you must use real property valued at least $500,000 in your business on a continuing basis. Does her home count? She makes the candles in her kitchen. No, private dwellings are excluded unless she has a dedicated commercial workshop or a farm shed worth $500,000. She fails this test. Test four: the other assets test. This looks at your equipment, trading stock, and plant. To pass, the value of these assets must be at least $100,000. Note, you generally cannot count cars in this test. So unless Sarah has $100,000 worth of wax and melting pots, she fails this too. So Sarah has failed all four tests. Income less than $20,000, no profit history, no commercial property, assets less than $100,000. So what is the verdict? The verdict is: non-commercial loss. She cannot claim the $4,500 loss against her nurse salary this year. She must defer the loss; it rolls over to next year. That seems tough for startups. Is there any way around this? What if I'm growing a business that can't make money yet, like a vineyard? Ah, this is the exception: the Commissioner's discretion. You can apply to the ATO and say, "Please let me claim my loss even though I failed the tests." There are two main grounds for this. Ground one is lead time. Explain that. Some businesses have a biological or commercial lead time before they can make revenue. Example: planting macadamia nuts. It takes seven years for the trees to produce nuts. You will have seven years of losses with zero dollars revenue. The ATO understands this. If you can prove that your industry has a standard lead time, they will grant you discretion to claim the losses during that growth phase. But does finding customers count as lead time? No, that is just business. "I need time to build my brand" is not a valid reason for discretion. It has to be inherent to the nature of the business. For example, waiting for trees to grow, waiting for a patent approval. Ground two is special circumstances. This is for when disaster strikes. Flood, bushfire, drought, or a global pandemic. If Sarah's candle factory burned down or if a government lockdown forced her to close, she could apply for discretion. She would argue, "I would have passed the $20,000 test, but the fire stopped me." If the ATO agrees, they let her claim the loss. Now we have to talk about the heroes again: primary producers and artists. They get a free pass, right? They do. The government wants to support farmers and the arts. If your business is primary production—farming—or professional arts—writing, painting, performing—and your other income from salary is less than $40,000, you are exempt from the tests. So a struggling actor who earns $30,000 a year working at a cafe can claim their acting losses? Yes, because their other income is under $40,000. But if that actor gets a big corporate job paying $100,000, the exemption is gone. They have to pass the four tests like everyone else. We often hear people say "just start a company." Companies don't have these rules. Is that a good strategy? It's a common strategy, but it's not a magic bullet. Yes, the non-commercial loss rules do not apply to companies. So if Sarah starts Sarah's Candles Pty Ltd, the company can carry forward the loss without passing the $20,000 test. However, a company is a separate legal entity. The loss is trapped inside the company. Sarah cannot use a company loss to offset her personal nurse salary. So she still doesn't get the refund? Correct. She avoids the tests, but she still doesn't get the cash benefit personally. The only way to offset a loss against your salary is to be a sole trader or partner, which puts you right back in the non-commercial loss rules. It's a catch-22. It is. That is why the best tax strategy is simply make a profit. Focus on getting your revenue over $20,000. Once you hit that magic number, the gate opens and you can claim your losses, if you have any left. So summary for Sarah: check you are actually a business, not a hobby. Check your other income is under $250,000. Try to hit $20,000 revenue—Test 1. If you fail, accept the deferral; it's not lost, just waiting. And if you think you have a lead-time argument, like you are planting truffles or breeding racehorses, talk to Ben. Those applications are complex and you need independent evidence to prove your case to the ATO. We hope today's discussion has provided you with valuable insights. Before we go, a quick but important reminder. The information shared today is for general informational purposes only and does not constitute specific tax or financial advice. Everyone's situation is unique and tax laws are complex. For personalized advice tailored to your situation, we always recommend consulting with a qualified professional. Connect with Ben and the team at Aevum Accounting. Visit us at aevumaccounting.com.au. That's it for this week. Good luck with the side hustles. Until next time, stay savvy, stay profitable. And sell those candles. See ya.