Ring-fencing of losses derived from rental properties
By now I’m sure most of you will be aware of the new rental property ring-fencing rules which have been introduced with effect for the 2019/2020 income year. For most taxpayers, these take effect from 1 April 2019.
These rules were proposed back when the property market was booming and seen as another way to slow the property market by limiting (or ring-fencing) the deductibility of residential rental costs of investors to the quantum of residential rental income derived.
Timing of these changes
Although these changes may have been proposed when the property market was booming as a way to help increase the home ownership statistics, the actualisation of these rules has come at a time when the property market is slowing. These changes also come into effect following a period of time where residential property investors have been hit with numerous changes to slow the property market, such as the introduction and then widening of the bright-line test insulation requirements, healthy homes, tenancy act changes and tribunal decisions, foreign buyer restrictions, LVR rules and a tightening of credit in New Zealand.
Tax deductions post bright-line rules
Prior to the introduction of the ring-fencing rules, investors were able to offset excess deductions from their residential property against other sources of income (for example – their salary, business income), and reduce their income tax liability in this way.
Under the new rules, deductions will only be able to be offset against residential rental income. If there are excess deductions at year end, these may be carried forward to be offset against future residential rental income, although, as with most tax legislation, the devil is in the detail.
A person’s main home is of course excluded as it is outside the tax net, as well as both property subject to the mixed-asset rules (such as the holiday home if rented out), and property that will be taxable upon sale (that is, held on revenue account similar to land utilised by developers).
Where multiple residential rental properties are owned there is an ability under the rules to treat the ring-fencing of the losses on a portfolio basis or on a property-by-property basis. The default method is the portfolio basis and a taxpayer must elect to treat each property individually if so desired.
Where properties are owned through other entities, the rules become more complex. For example, if a residential rental property is owned through a Look Through Company (“LTC”), the owner is treated as making an election, not the LTC.
Included within the ring-fencing rules are limitations on interest expenditure when the borrowing goes towards acquiring an interest in a ‘residential land-rich entity’, so dropping properties into a company may not be as effective as you have heard. However, if residential rental properties are owned in various companies within the same wholly-owned group of companies, there is some ability to offset losses with other residential rental income within the wider group.
Into the future
Whether the policy will effectively address the issue of unaffordable housing, we will have to wait and see. One thought is that that the cost of a reduced tax benefit could be passed on to the renters themselves through increased rental prices.
Irrespective of your views on the validity or otherwise of the underlying policy, these new rules are now effective, and may either materially affect the business case for your residential property assets or change the nature of your overall tax obligations. Consequently, we recommend obtaining specialist tax advice on your portfolio to understand how the rules will impact on your tax position and whether it is time for a restructure of your property portfolio, bearing in mind other land rules (such as the bright-line rules). It is also worth reviewing your cashflow budgets with your adviser if necessary.