Residential Rental Losses – A Change is Coming
Earlier this year, IRD released a paper on the proposed ring-fencing of rental losses, expected to come into effect for the 2019/20 tax year. Here’s a brief summary of that paper.
The implementation could be phased in over 2-3 years or it could be brought in in one fell swoop for the 2020 tax year. If it were phased in, it would reduce the proportion of losses that could be deducted each year – eg 50% in Year 1, 25% in Year 2, nil in Year 3.
The paper also discusses capital gains tax and it is strongly indicates that IRD is of the view that:
- Rental housing may be under-taxed because it is not generally subject to a capital gains tax
- If a residential rental property makes a loss, then that loss should only be deductible if capital gains were also taxed.
So, depending on the outcome of the tax working group’s recommendations, there is the possibility that the proposed ring-fencing rules may be just an intermediary step. While there has been a lot of talk about capital gains on residential rental property over the years, the cost of implementing may far outweigh the additional tax generated. At the moment the housing price increases are slowing which mans no profit would be generated.
What is proposed.
At the moment, a residential rental loss can be deducted from other forms of income – wages and salaries or business income. As a result taxpayers could get a tax refund every year. More often than not, the loss is generated from high debt levels, even if the interest rates are low.
From 2019/2020, the loss will be limited to the rental income earned, calculated on a portfolio basis. In other words, it is the total rental profits or losses from all residential properties that will be considered.
The losses will be carried forward and they will be able to be offset against:
- Residential rental income from future years, from any property, and
- Taxable income from the sale of any residential property eg depreciation recoveries, or if the property is taxed under the brightline rules.
If you own a mixture of commercial and residential investments, it might be possible to load more debt on to the commercial property and have a smaller level of debt on the residential property. The usual interest deductibility rules look at where the funds were used rather than what security is provided for the funding. When it comes to holiday homes, there are already stacking rules that apply debt first to the holiday homes ahead of other investments. But it is not currently proposed that there are specific interest allocation rules.
What sort of property is covered.
The legislation will apply to all residential rental property whether it has a dwelling on it or not, whether rented or not, whether in NZ or overseas. It specifically excludes:
- A person’s main home
- A property that is subject to mixed-use rules – eg a holiday home
- Land that is held on revenue account – ie where any profit on sale is subject to tax
- Non-residential property, or farmland.
There will be rules to ensure that the use of an intermediary entity – eg a trust, company or look-through company – does not subvert the rules. A new concept proposed is to create rules for a “residential property land-rich” entity that treats all distributions from those entities as being residential rental income, and treat borrowings to acquire shares in those entities as being rental property loan interest. The interest paid could only be deducted to the extent of the income received.
Residential rentals as an investment strategy
We encourage our clients to improve their personal wealth through the creation of passive investment cashflows. These could be through equity investments, property investments or even through building a business that is no longer dependent on the owner.
A team of economists from the University of California, Davis, University of Bonn and the German central bank undertook a research project on 145 years of investment returns economic data and published a paper called The Rate of Return on Everything , 1870-2015.
The result? Residential real estate had the best returns, averaging over 7% pa. Equities weren’t far behind at just under 7%.
Residential rental properties have the advantage of being relatively easy to fund through bank debt which makes it easier for people to start their wealth journey with a rental property. These changes in tax rules will not provide the same immediate tax benefit to property owners, but the fundamentals of investing still hold true:
- If you want to create passive cashflows residential rental properties are well worth considering
- The fact that they can be debt funded will reduce the barrier to buy a property in the first place
- If you buy a good rental property at the right price, there will be positive cashflows in the future
- The ring-fenced losses should be capable of being fully used – it not right now, then at least some point in the future when the debt has been reduced.
In the meantime, if you’re a landlord and there’s some expensive maintenance planned for the near future (re-roofing, or painting, for example) you might want to bring that forward so it is completed by the end of March 2019. You’ll be able to get a full deduction for the cost, even if you have to pay for the work a little earlier than intended.