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Ring-Fencing Rental Losses
Presently, if you own a residential investment property, and it costs you more to operate for a particular income year, than the rental income you receive from your tenants, you make a rental loss which can then be offset against any other income you earn, thereby reducing the overall amount of tax you need to pay. Unfortunately, all this is about to change.
In March of this year, we saw the release of an Issues Paper jointly by Inland Revenue and Treasury, outlining a proposal to ring-fence rental losses related to residential investment properties. The release of the document came as no real surprise however, considering the Government had previously advised its intent to quell the overheated residential property market, which in its view was being stoked by speculators and investors, by using such a tool to dampen demand from these types of purchasers.
The devil in the detail of how the new rules will work in practice, will not be known until Official’s have had an opportunity to fully consider all submissions made on the proposal (required to be filed no later than 11th May), and the draft legislation is released. However in its current form, the new rules would apply as follows:
- The intended commencement date would be the start of the 2019-20 income year, although there could be a phase in period of two to three years.
- The ring-fencing would only apply to residential land and it is proposed to use the existing definitions contained in the bright-line test to determine what land is affected in this regard. Note that if you are a NZ tax resident, the rules, as with the bright-line test, will apply to residential land owned anywhere in the world and not just within NZ.
- The rules would mean that any loss from your residential rental investments could no longer be offset against your other income sources. Consequently, any loss would carry forward to future income years, for offset against future residential rental income or other taxable income arising from the sale of residential land – for example a profit from the sale of land that was acquired with the intention of resale.
- The ring-fencing would be on a portfolio basis however, meaning that a loss from one residential property could be offset against the profit from another residential property that you own.
- The rules would apply irrespective of the ownership structure you used to hold your residential investment properties – company, trust, partnership, look-through company, etc. Additionally, there would be rules to prevent you indirectly financing the investment, by say borrowing monies to acquire shares/ownership interests in the asset owning entity, and attempting to claim an interest deduction on this basis, rather than as a direct component of the rental loss itself.
- Similar to the bright-line test, there would be limited exceptions to the rules, the proposal that the following residential land would not be subject to ring-fencing:
- The main home (of which there can only ever be one at one time);
- Land subject to the mixed-use asset rules (e.g. holiday homes since there is already quarantining of losses);
- Land held on revenue account (since all income from the property is taxable i.e. no potential for capital gains); and,
- Farmland and land used predominantly as your business premises (since this land is excluded from the residential land definition).
To illustrate the application of the new rules, the following example presents the differences between the current and the proposed rule for various income bands for an individual investor, when considering a residential investment property that has an annual loss of $20,000:
The Government has justified introducing the ring-fencing rules on the basis that it is aimed at levelling the playing field between property speculators/investors and home buyers. It has suggested that the benefit of the tax offset enables a speculator/investor to outbid the homeowner simply because their mortgage will be subsidized as a result. So this logic would suggest that a prudent investor would be prepared to pay a higher price for a piece of land simply because they get a tax deduction? Possibly, but in my view this is again, like the recent extension of the bright-line period from two to five years, a political response and overreach of what is really required to fix what in essence is an Auckland supply versus demand problem. I would also raise the following questions/concerns:
- What happens to all those homeowners the Government is supposedly trying to protect, if there is a correction in the market, potentially downwards, where homes were bought at the height of the bubble, excessively geared and suddenly the lenders have assets on their books that are inadequately secured. Are the banks for example going to be prepared to carry the risk?
- What if the tax working group (TWG) recommends a comprehensive capital gains tax be brought in, which this Government then acts upon? Why do they not wait until the TWG releases their final report early in 2019, and then act accordingly?
- What happens to the rental stock available and consequent level of rent payable by tenants if the Government achieves its aim of removing investors/speculators from the residential property market?
- What about the Government’s promise not to introduce any new taxes during its first term? Some would suggest the additional taxes illustrated above, is in effect a new tax on those affected by the new rules.
Naturally there is a glimmer of hope that the proposal will not proceed, and even if it does, that a change of Government for the next term could see a reversal of the new rules soon after their introduction, however I suspect we are just going to have to take a wait and see approach.
Author: Richard Ashby
“Back to the future” – a great movie.
Ring Fencing has been done before and failed.
For those old enough to remember Muldoon, who wanted to beat tax avoidance, he created a system called ‘specified activities regime’. This included buying and renting property, then limiting the losses to $10k pa from all such activities to each taxpayer. In the early 80’s, the property market was growing even more strongly than it has this time and everyone was gnashing their teeth on how to fix it. Muldoon’s answer was a rent freeze, making it illegal to kick a tenant out and freezing interest rates (below the rate of inflation), thus locking in the poor landlords’ loss. It had the consequence of making finance unavailable which then meant you couldn’t sell your properties either. Bob Jones got him though by forming a political party, the NZ party, and then he was biffed out in 1984 and the regime was eventually repealed.
Bromhead, a wonderful cartoonist for his time, has a cartoon of a beggar (clearly a lawyer) on the street outside an office building, that was obviously Russell McVeagh’s building, the key architect of the tax shelter industry of the time, with a caption, “a penny for my tax shelter”.
So my pick… it won’t work! Jacinda, beware, Bob Jones still breathes.
Comment Author: Bruce Sheppard