The Government believes there is a perception held by the general public that landlords have an unfair tax advantage, which is helping them outbid owner-occupiers for residential properties.
The latest paper on “ring-fencing rental losses” released by Inland Revenue demonstrates that Government is now one step closer to “punishing” landlords and property speculators for causing the house prices inflation.
Under the proposed rules, property investors and speculators with residential properties will no longer be able to offset losses from those properties against other income (e.g. salary or wages, or business income), to reduce their income tax payable.
Landlords and speculators are treated the same despite having different intentions and different holding periods. Landlords usually hold long term, while speculators look for a quick turnaround.
Similar to the Bright-line Test, the proposed rental ring- fencing rules only apply to residential land only, including overseas rental properties. Excluded from these rules is commercial property, a person’s main home, mixed-use assets and land that is on a revenue account held in land-related business (e.g. part of a business of land dealing, development or division of land or buildings).
The rental losses won’t disappear. Instead, they will be “ring-fenced” and be carried forward to offset against any residential rental income or taxable gain on the sale of any residential land derived in future year(s). Any remaining unused losses would continue to carry forward until there is income to be offset against in future.
A positive note is that taxpayers with multiple rental properties under a portfolio can offset losses from one rental property against rental income from another portfolio, to arrive at the overall profit or loss across their portfolio.
What this means is that landlords especially those with a small rental portfolio (say, with one rental property), or those with lower equity or those that are negatively geared, will be hit hardest by the rule change. Rental losses are often driven by high interest payable on mortgages on those rental properties. Instead of getting tax refunds to fund their rental mortgages under the current rules, these refunds will stop which will inevitably have an impact on cashflow moving forward.
Below is a simple example to illustrate how the proposed property rules work:
Example 1 - Andy's income tax positions under the current and proposed rules:
In this example, Andy can currently offset rental losses against his salary and wages, thereby reducing his taxable income for the year, giving him a tax refund of $4,813 at year end when he files his tax return. He would no longer receive the refund under the proposed rules. If we replace “salary and wages” with “business income” with no tax deducted at source, Andy would potentially have a provisional tax issue, which requires careful tax planning.
The proposed rules will apply to individuals as well as trusts, companies (including LTCs), and partnerships, with no exceptions.
As with all things tax related, Government are concerned about the ways that taxpayers may try to work around the new rules. The two most obvious ways would be increasing interest costs through reorganising funding, or by holding property in an interposed entity.
Relating to the first, enacting specific interest allocation rules was considered. It was decided that interest allocation rules would add complexity and compliance costs and this would be too onerous for taxpayers.
Interposing entities is receiving sharp focus. A rule against claiming interest deductions incurred when buying shares in a company which owns residential rental property is to be enacted.
As with all things tax related, Government are concerned about the ways that taxpayers may try
to work around the new rules. The two most obvious ways would be increasing interest costs through reorganising funding, or by holding property in an interposed entity.
“Residential property land-rich” entities which distribute profits to a shareholder will result in those distributions (dividends or interest income) being treated as “rental property income”. A threshold of 50% of the entity’s assets being residential property to fall into this definition. How this works in practice remains to be seen.
Interest on borrowings to acquire shares in such a company would be deemed “rental property loan interest”. Any excess interest over income will be carried forward and cannot be used to reduce assessable income from other sources.
The proposed effective date is the 2019/2020 income year. As this is a deviation from well-established tax rules, there is scope for the rules to be phased in over two or three years.
These changes will affect anyone with a residential rental property. There is a narrow window of opportunity to take tax advice on your affected property investment, so come and speak to the team at Bellingham Wallace.
www.bellinghamwallace.co.nz
