Ringfencing of Rental Losses
Ringfencing of Rental Losses
Finally, after months have passed since the issues paper was released for submissions, the government has released the bill that is set to ring fence residential property losses.
The law is predicted to raise a further $190 million annually from the property sector. Alarmingly, the government admits in its risk analysis that it has no real idea what the
law will do to the housing market and expects to be unable to identify the direct impacts due to the other initiatives being deployed to dampen the housing market at this time.
So, what is loss ringfencing?
Ringfencing is designed to prevent a taxpayer from offsetting a legitimate tax loss from a residential investment portfolio against other forms of taxable income. The loss from
the rental property must be “ring fenced” and carried forward to be offset only against future taxable income from the rental portfolio. That income could be in the form of future
rental profits or taxable income from a land transaction or Brightline disposal.
Why are they doing this?
Because they see investors gaining a tax saving from a rental loss without the requirement to declare capital gains as income. They see this as being a contributing factor to the
housing crises with first home buyers at a disadvantage when pitted against investors.
So what are the key features?
Firstly, the bill is very closely aligned with the original issues paper that was released that formed the basis of the submission our firm made on these rules.
Very little has changed, but it does seem the government has been somewhat challenged by the question of whether to ring fence on a portfolio basis or a property by property basis.
Here’s the rub, . . .
The bills default position is to ring fence on a portfolio basis but there is an opt out elective option if you wish to have your loss ring fenced on a property by property basis.
Ring fencing on a portfolio basis means that if overall a property portfolio is profitable, there is no ring fencing just because some of the properties in it may make losses. This is
a huge issue with the effectiveness of this legislation because it means an investor with a profitable portfolio can add a loss making property to it and still gain a tax advantage
provided the portfolio overall is still profitable. But an investor buying the same property who does not have other rental income to offset the loss against is ring fenced and can’t
gain the same tax saving.
With interest rates at 4%, more or less level with residential yields you don’t need much equity now to be profitable. Our client survey indicated 65% of residential property investors
we act for are in fact profitable and paying tax.
This legislation therefore creates two types of residential investor, those that are profitable and can grow their portfolios continuing to gain tax advantages by offsetting losses
against existing rents and those that aren’t who must suffer the effect of the ring fencing.
On first look, its very hard to imagine why an investor would elect voluntarily to have their losses ring fenced on a property by property basis but seemingly, the addition of this
option may represent the governments attempt to somehow address the unfairness of a portfolio based approach. Has it worked? No.
Other key features of the bill
The bill will only apply to residential land as defined by the definition in the Brightline legislation. ( see below)
The rules will not apply to a taxpayers main home
The rules will not apply to holiday homes subject to the mixed use asset rules where they are partially rented and partially used for private use.
Ring fencing will be on a portfolio basis with an elective option to apply the rules on a property by property basis.
Ring fenced losses will be able to be used to offset future income from residential land or taxable gains from the sale of residential land.
There will be anti-avoidance rules preventing deductions for interest on money borrowed to buy shares in property companies where the companies assets are
50% or more property.
The bill will take full effect from 1 April 2019 for the 2019 – 2020 year.
Losses from overseas residential properties will also be ring fenced.
Ring fencing will not apply to revenue account property where the proceeds of sale are definitely taxable
The rules will not apply to employee accommodation where the remoteness of location of the business forces it to provide accommodation to employees
So what is the definition of residential land ?
Residential land means land that has a dwelling on it or land for which there is an arrangement to build a dwelling on it or bare land that may have a dwelling built on It
under the operative district plan. Residential land does not include farmland or land used predominantly as business premises.
In our firms submissions, we called for a clearer definition of business premises but this has not been addressed. This leaves questions like “is a serviced apartment leased to
an accommodationprovider exempt as business premises” unanswerable at this point.
Why are holiday homes excluded ?
The government believes that property subject to the mixed use asset rules which already ring fences losses if gross rent does not exceed 2% of a properties CV will be sufficient
to ring fence losses from most, if not all, mixed use assets. I do not share their view as it is relatively straight forward to achieve a gross yield of 2% of a properties CV through
casual letting but still make a loss if most of the money to buy the property is borrowed.
Releasing ring fenced losses.
In situations where a portfolio is sold and the sale proceeds are subject to tax, if there are excess ring fenced losses over and above the amount required to reduce tax to nil,
the remaining ring fenced losses will be released. But in situations where sale proceeds are not taxed, ring fenced losses will remain ring fenced after a portfolio is disposed of.
What about losses due to repairs and maintenance?
Withers Tsang’s submission called for a carve out of losses that were created to the extent that deductions flowed from repairs and maintenance to the buildings. Given the
leaky building crisis and the governments call to improve housing stock we did not see anybody gaining if landlords were disincentivised to undertake repairs. Unfortunately this
call has fallen on deaf ears.
So what is your advice now and what might the impacts of all this be ?
There are essentially three things an investor should do before these rules come into force on 1 April . . .
Firstly, review the maintenance requirements on your buildings. If you are budgeting for repair work in the future that would be costly enough to create a loss in your portfolio,
it may be sensible to consider undertaking this work in what remains of the 2019 tax year. You have only four months left to generate deductions that won’t be subject to ring fencing.
Secondly, if you are an investor with other business interests, consider booking a consultation to discuss the possibility of moving debts in your property entities to trading businesses.
For example,you may have a trading company where you can refinance a shareholder loan account or you may have imputed retained earnings that have been reinvested in the
business to date. Money could be borrowed in the business and used to pay out a dividend from retained earnings to shareholders who in turn use these funds to reduce debts in
the property portfolio. The resulting interest costs in the business are deductible without being ring fenced and the property portfolio’s position is improved.
Thirdly, If you do have a loss making residential property portfolio, consider booking an appointment to examine the opportunity cost of retaining low yielding properties. If a property
can be sold where more interest is saved through debt reduction than the lost rental income from the property the overall portfolio becomes more profitable, and now, more tax effective.
What will be the consequences of all this be?
The introduction of ring fencing on top of the five year Brightline and the foreign buyer ban and the changes to the residential tenancies act will further dampen Kiwis enthusiasm
for residential property investment.
I believe those investors who are willing to buy more property will set their price expectations relative to a yield that will deliver a taxable profit because there is no tax upside now
to booking losses. Given residential rental property yields are currently typically below the cost of funds I believe the value of residential investment properties will fall to deliver the
buyers that remain higher yields.
Will rents also rise, yes probably, if the net result is that residential landlords withdraw from the sector leading to a shortage of rental property, rents will rise.
I suspect there will be a combination of both a fall in value of residential investment property and an increase in rents to arrive at an equilibrium where investors will buy to drive
The question now is, how many investors will still be willing to catch a falling knife?
I also suspect investors will contemplate the commercial property investment market where losses are not ring fenced and properties are not subject to the Brightline rules.
From a tax perspectiveat least, the differences between the way the rules apply to residential and commercial property is now cavernous.
The introduction of loss ring fencing and the five year Brightline rules is set to fundamentally alter the taxing outcomes of residential property investment in New Zealand.
The team at Withers Tsang stands ready to advise and assist you to navigate the best possible path forward with this brave new world.
Please call to book a consultation if you would like to review the impacts of these changes on your own specific circumstances.