This means preventing the investors from applying losses incurred on holding a property against their personal salary/wages and other business income.
The government’s stated aim is to make the tax system fairer and improve housing affordability for owner-occupiers by reducing demand from speculators. That is admirable.
However, as we explain below, it’s questionable how creating a tax rule that only applies to a single class of asset, residential property, and not to other types of assets, makes the tax system fairer.
Inland Revenue (IR) recently released a paper setting out the details of this proposal, with the intention to have it apply from the 2019/20 year (i.e. 1 April 2019 for most taxpayers).
The IR’s position is that losses should not be able to be offset against the investor’s other income – only current and future investment property income, including any taxable capital gains made on the ultimate disposal of the property.
Proposed rules are for residential land only
The proposal is for the rules to apply only to “residential land”, not farmland or land used predominantly as business premises.
Excluded from the rules would be a person’s 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).
The rules would apply to all residential land, whether or not it is currently rented out, including bare land, and land outside of New Zealand.
To apply on a portfolio basis
IR suggests that the rules should apply on a portfolio basis, instead of on a property by property basis.
That is, investors would be able to offset losses from a loss-making property against other properties in the portfolio that may be profit making.
Structuring around the rules
The rules could be circumvented by investors holding their property in different types of entities, as opposed to investors holding directly in their personal capacities.
For example, a taxpayer could borrow money to purchase shares in a company that invests in residential property. Interest incurred by the taxpayer on money borrowed to buy the shares would be tax deductible to the taxpayer.
So, while the shareholder is not borrowing money to purchase the property directly, they could still obtain the tax advantage by borrowing to purchase the shares in the company.
The IR is proposing rules that catch this sort of structuring. However, it is not proposing any rule that would prevent taxpayers structuring their affairs in such a way that other business assets the investor may have are debt-funded, while their rental property investments are equity-funded to the extent they can be.
Comparison with other types of investments
The tax system does not favour residential property investment over other types of assets such as shares or business assets.
Investors in other asset classes can offset losses they incur in holding such assets against their personal income.
Further, investors in other asset classes may not pay any capital gains on the sale of their investments in the same way property investors may not.
It’s worth noting that the losses investors make on holding rental properties are not the product of alchemy or some nefarious sleight of hand.
It would cost an investor on the top 33 percent marginal tax rate, $67 to derive a $33 tax advantage from losses on an investment.
In other words, the investors are incurring a real economic cost in excess of the tax benefit they obtain.
IR points out that the ultimate tax benefit for investors and speculators is often tax-free capital gains made on the sale of a property. Often perhaps. But not always.
And therein lies the rub – the government is spreading its tax net widely.
As with the two and five year bright-line rules that apply to tax capital gains on the disposal of a residential investment property, the ring-fencing rule will not discriminate.
It will catch non-speculators who are genuinely holding their properties as a long-term investment.
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.