Ring-fencing rental losses
Residential property investors should familiarise themselves with proposed changes to the tax laws before parliament ring-fences losses from rental properties, impacting cash flow for property investors.
PROPOSED CHANGES mean property investors will no longer be able to deduct expenses relating to their loss-making residential investment properties from their other income, such as salaries, wages or business profits. The changes set out in the Taxation (Annual Rates for 2019–20, GST Offshore Supplier Registration, and Remedial Matters) Bill will apply from the start of the 2019/20 income year. For most of us, that means from 1 April 2019.
Losses from rentals used to lower tax
The typical scenario for residential property investors is to use the existing equity in their home to borrow up to 100% of the purchase price of a residential rental property. The rent received minus ensuing interest charges, together with rates, insurance and repairs create losses. These losses then reduce business income or PAYE salary, resulting in lower tax payable or cash refunds.
As the mortgage on the rental property begins to reduce, so does the interest charge and eventually the rental property begins to make a profit. Typically, the process is repeated again with a second rental property acquired using the equity in the first. Losses continue to be generated, thereby reducing other taxable income.
The process continues until the person has a decent portfolio of rental properties. On the basis that these properties are owned for at least 5 years, the absence of any capital gains tax allows the investor to sell down those properties over time to fund retirement needs.
Changes will ring-fence losses for future years
According to the current government, this is not cricket, and a new law will remove the ability to offset rental losses against other types of income.
The proposals are going to use the same definition of residential land that already exists for the 5-year bright-line test that taxes gains on disposals of most residential property if sold within 5 years of purchase. Property subject to those mixed-use asset rules and property that is ordinarily taxed on sale – say because you are developer or builder – will not be included.
Any excess of expenses over income from rental properties will be ring-fenced and they will have to be carried forward to future years. Those carried-forward losses will only be usable against future rental income earned from residential properties.
Will impact cash flow for some investors
This may have a significant effect on cash flow for some property investors, particularly those who need the reduced tax or refunds for maintenance or to reduce debt. Accordingly, you need to see these new rules largely as a timing deferral for when you can use the losses. The only difficulty is of course that you need cash now for maintenance, debt reduction and income tax.
These new rules will look at residential rental properties as a portfolio, meaning if rental property 1 makes a loss, you will be able to offset that loss with the profit from rental property 2. You do not have to wait until rental property 1 makes a profit before you can use its loss.
Overseas land in, but some employee accommodation out
Under the existing definition of residential land, Gold Coast apartments and any other land you own overseas will also be included in this regime.
Importantly, these rules will not apply to employee accommodation that is necessary because of the nature or the remoteness of the business. Farmers and the like should therefore be fine.
Includes ownership by trusts and companies
Some property investors use trusts and companies to own their residential rental properties. The new rules extend to these entities as well. More sophisticated investors might choose to borrow money from the bank in their own name to buy shares in their residential rental company.
The interest charged by the bank to them personally would relate to them purchasing shares rather than purchasing a residential rental property. In the absence of other restrictions, because the ring-fencing proposals appear to only apply to interest charges in respect of residential rental properties, the interest would be fully tax deductible.
Inland Revenue has thought of this and has concluded that, if your company or trust is considered land rich – over 50% of the assets are residential rental properties – your interest expenditure will be treated as residential property rental expenditure. This will be calculated with reference to the trust’s or company’s capital being used to buy the residential rental.
Example of company scenario
Inland Revenue’s commentary in the Taxation Bill includes the scenario in Figure 1 to help explain the position for those using a company to own their residential rental properties.
More than 50% of the company’s assets are residential rental and so company X is a land-rich entity. Of company X’s total capital of $1,050,000, $1,000,000 (95.24%) was used to acquire a residential rental property.
This applied capital percentage is then multiplied by the interest cost incurred by Alex of $45,000, giving an amount of interest that relates to residential rental properties of $42,858. The balance of the interest incurred, being $2,142, can be claimed in full as it does not relate to residential property.
Company X has earned a profit of $40,000. Therefore, under the ring-fencing rules, the interest deduction in respect of residential rental is limited to $40,000. Added to this is the $2,142 arising from non-residential rental expenses. This gives a total interest deduction of $42,142 for Alex and a loss carried forward of $2,858.
Note
This is a complex area and Staples Rodway strongly recommends you take professional advice before dealing with these changes.
Download the PDF
Articles are correct at the time of publication but may have since become outdated.
