The IRD estimates that approximately 40 percent of taxpayers with residential rental properties make tax losses, and the average annual tax benefit to these taxpayers is $2000.
This tax benefit will largely end from 1 April this year, on the enactment of legislation introduced in December that will ring-fence these losses. Investors will not be able to deduct expenditure relating to their loss-making rental properties from their other income, such as wages/salary and business income.
However, there will be limited circumstances where investors will be able to deduct their losses from other income. There will also be legitimate opportunities to mitigate the adverse effects of the new rules.
The government’s rationale for the rule change was that it was attempting to level the playing field for owner-occupier home buyers, allowing them to compete with investors.
An unintended – but well-signalled – effect of the legislation is that investors may look to pass on the cost through increased rents.
If the hoped-for policy outcome eventuates of home-occupiers displacing investors and buying more residential property, then supply and demand pressure alone could cause rent increases. On average, owner-occupier housing tends to have fewer people per house. So, unless there is an adequate flow of new housing onto the rental market, the amount of rental housing available to renters could decrease.
As Treasury has pointed out to the Minister of Finance in its regulatory impact statement, there is significant uncertainty around the effects. A knee-jerk policy response may very well exasperate the plight of renters.
What land will the rules apply to?
The new rules will only to “residential land,” not farmland or land used predominantly as business premises.
Excluded from the rules would be a person’s main home, property subject to the mixed-use asset tax rules (e.g. a bach used privately that is also rented out), or land that is taxable due to being part of a land-related business (e.g. land dealing, developing, building). Certain employee accommodation and property held by widely held companies will also be excluded.
The rules would apply to all residential land, whether or not it is currently rented out, including bare land, and land outside New Zealand.
What happens to the ring-fenced losses?
The ring-fenced losses will be able to be offset against residential rental income from future years, and any taxable income on the sale of residential land to the extent of the income. Losses in excess of the income will generally continue to be ring-fenced.
In situations where the properties end up being taxed on sale, remaining unused losses may be released, so they can be offset against other income as they can be currently – e.g. salary, wages, business income.
However, whether these leftover losses can be released will depend upon whether the properties are accounted for on a portfolio or property-by-property basis.
Portfolio versus property-by-property
The default position is that the loss ring-fencing rules would apply on a portfolio basis. This means investors would be able to offset deductions from one property against income from other rental properties they may hold, essentially returning their overall profit or loss as a single amount.
If an investor wants to return the income and expenditure on a property on a standalone property-by-property basis, then they will need to elect to the IRD to do so.
While the portfolio approach may have benefits from a cashflow perspective, it may not always achieve the best outcome, particularly where a property will be subject to tax on sale. Situations where a property may be taxable on sale include where it was acquired with the intention of disposal, the property is sold within five years of acquisition (i.e the brightline rule), or generally where the taxpayer is in the business of building, dealing in, or developing property.
Properties that will definitely be subject to tax because they were acquired with the intention to sell, or are part of a land dealing, dividing or building business, will be excluded from the rules (and so losses will not be ring fenced) provided:
- The investor notifies the IRD of the rental income and expenditure for that property on a property-by-property basis; or
- The investor notifies the IRD of the rental income and expenditure on a portfolio basis and all the properties within the portfolio are subject to tax on sale.
Provided the above criteria are met, a similar outcome will be achieved for properties that may be subject to tax on sale depending on the subsequent actions of the investor, such as whether the property is disposed of within five years under the brightline test.
Structuring around the rules
The legislation contains a rule to prevent interposed entities being used to circumvent the rules. For example, an investor could borrow money to purchase shares in a company that owns residential property. Interest incurred by the taxpayer on money borrowed to buy the shares would under normal tax rules be tax deductible to the taxpayer.
The rule would apply where someone has borrowed to acquire an interest in an entity where greater than 50 percent of the entity’s assets are residential properties.
The government is not proposing any rule that would prevent taxpayers structuring their affairs in such a way that other business assets the investor has are debt-funded, while their rental property investments may not be.
The comments in this article are of a general nature and should not be relied on for specific cases, where readers should seek professional advice.