Rental property losses - ring-fenced for the sake of housing affordability?
In the March 2018 issue of Policy and Strategy, Inland Revenue published an officials’ issues paper which advocates that the Government has committed to policy measures aimed at making the tax system fairer and at improving housing affordability. The paper then claims that one of these measures is to introduce ring-fencing of losses on residential properties held by speculators and investors.
For years, owning a rental property or properties has been the investment of choice for many Kiwi’s. Newspaper articles with headings such as “Thirty year old buys third rental property” continue to be read with admiration by many. Further, investment courses that promise riches from the residential housing market, boom or bust, seem to thrive.
At least part of this phenomenon is due to the ability to offset rental losses against other income. Even if the other income is a salary from employment, it is possible to get a refund of the PAYE paid through the employer’s payroll. This is often factored into the rental property business plan, and the decision whether or not to invest.
Alas, this utopia seems to be coming to an end, with the proposal to ring fence such losses. Briefly, ring-fencing means that you will not be able to offset any rental losses against your salary, business or investment income, but rather only against other current year rental profits or future year rental profits.
This effectively means that if you have only one rental property and you want a tax advantage, that property will have to make a taxable profit sometime in the future. Alternatively, if you have more than one rental property, at least some of them must be tax profitable if you want to use tax losses in the current year.
To somewhat state the obvious, the tax losses on rental properties mostly arise because the deductible expenses exceed the rental income. Deductible expenses usually include insurance, rates, taxes, repairs and maintenance and the interest paid on the loan to purchase the property. The interest is of course a direct result of the size of the loan. Since a higher interest amount leads to a higher tax loss, the size of the loan increases the amount of the ‘tax subsidy’ in the form of a tax refund.
Rental property owners are willing to operate their rental properties at a loss in the expectation of a tax-free capital gain in the future. This is a peculiar situation, as the property owner takes current year taxable income into account in anticipation of a future year tax free capital profit. Not only has the waiting period for that future gain recently moved out to at least 5 years (under the new bright-line rules to come into force in 2018), but now rental property owners will lose the tax subsidy on highly geared properties, if the proposed legislation goes ahead.
In summary, the paper suggests:
- The ring-fencing rules will apply to “residential land” (not bare land).
- Main home and mixed use assets (some batches) will be excluded.
- Strict rules against structures to avoid the ring-fencing (“land-rich entities”)
- Proposed to apply from 2019-20 income year, possibly phased in over two or three years.
- Will apply to individuals, companies and trusts.
- Will not apply to revenue account land in land dealing, development or building businesses.
One of the main criticisms of the proposed policy is that it singles out the residential property market. The same investor might switch to equity investments and continue to enjoy the tax subsidy and tax free capital gains.
The paper states its aim of leveling the playing field between a rental property owner and home buyers, since the latter does not have the advantage of a tax subsidy. Effective markets need speculators and investors, need risk takers to provide capital to invest and to stimulate growth. The proposed change will certainly be a deterrent for many who might otherwise have considered becoming (or remaining) a rental property landlord, and that is bound to have an impact on the availability of rental stock and eventually, the market rent of such properties.
It seems that the end game is the abolishment of tax free capital gains and it is happening by stealth!
By Martinus Naude, Director, Business Advisory