UHY Haines Norton’s Managing Director Grant Brownlee explains how the proposed ring-fencing of residential rental losses will impact residential property investors.
The recently proposed ring-fencing of rental losses rule change is the result of a politically expedient election promise that blamed residential investors and speculators for house price inflation. The Government should be transparent about the true cause of house price inflation. Asset price increases were caused by financial conditions created by the world’s central banks who made enormous amounts of cheap money available to stimulate the global economy after the 2008 financial crisis.
However, the Government appears determined to push ahead with their promise to prevent residential landlords from offsetting their rental losses against other income.
Inland Revenue and Treasury published an Issues Paper on ‘Ring-fencing Rental Losses’ in March 2018 and the Government reinforced the message in the Finance Minister’s budget speech in May. The Issues Paper is not a firm set of rules now but it proposes that they will take effect from 1 April 2019. The proposed changes are targeted at residential property investors only.
The following example shows how the proposed ring-fencing of residential rental losses will operate.
Residential Company Ltd is a ‘Look Through Company’ that owns a residential rental investment property (property A) that was purchased for $1,000,000 and is rented out at $750 per week. The property was 100% financed using the rental property and other family property as security for the bank. It makes a loss as follows:
Under current rules, the $13,856 loss can be offset against the shareholder’s other income. If the shareholder had a job earning a salary of $90,000 then by offsetting the loss they would effectively pay tax on $76,144, generating a tax refund of $4,572. From 1 April 2019 under the proposed rules the shareholder will not get a tax refund. Instead, the loss of $13,856 will be carried forward to future years to be offset against future residential rental profits.
However, the situation isn’t all doom and gloom for an investor with multiple residential properties. The Issues Paper recommends that the ring-fencing rules should apply on a portfolio basis, i.e. ring-fenced loss from one residential property can be offset against profit from another residential property. For example, if Residential Company Limited has another rental property (property B) which made a profit of $11,000 for the year then the loss of $13,856 from property A can be offset against the profit of $11,000 from property B. The net loss of $2,856 would be then ring-fenced and offset against future property income.
The ability of residential landlords to offset their losses against other income has been described by political spinners as a tax loophole. On the contrary, it is a tax mechanism available across the board to investors regardless of what type of business activity they are investing in.
For example, if a trader in the share market makes a loss then that loss can generally be offset against that person’s other income. Similarly, if an investor invests in commercial property, a business, bonds, property trading, construction or whatever, provided the investment is structured in a tax efficient manner, the loss can be offset against that person’s other income. It is incorrect to describe this ability as a tax loophole when it is available to virtually everyone.
The Issues Paper contemplates and closes the door on clever structuring by those hoping to get around the rules. For example, under the current rules, borrowing money to purchase shares in a company that invests in residential property would give rise to an interest deduction to the shareholder which can be offset against the shareholder’s other income. Under the proposed rules any interest costs incurred by a person investing in an entity that is ‘residential property land rich’ will be treated as rental property loan interest. A residential land rich entity is an entity that holds over 50% of its assets in residential properties. The effect of the proposed rules is to ring-fence rental property loan interest against future residential rental income.
In short, the proposed ring-fencing rules punish investors for choosing residential property over other forms of investment.
If you are a residential property investor the Ring-fencing Rental Losses Issues Paper is worth reading, and given the likely timing of the proposed new rules you may want to get your deferred repairs and maintenance done before 31 March 2019. The paper can be found at http://taxpolicy.ird.govt.nz/publications/2018-ip-ring-fencing-losses/overview.
Grant Brownlee is Managing Director at UHY Haines Norton. For advice on all aspects of Property Accounting including property investment, structuring and tax, email Grant at firstname.lastname@example.org or phone 09 839 0087.