Ring-fencing rental losses


Labour’s pre-election manifesto proposed a commitment to increase the fairness of the tax system and improve housing affordability.

In the six months since the Labour-led coalition entered Parliament, we have started to see changes filtering through. For example, the bright-line test which taxes profit derived on the sale of residential property has already been extended from two to five years, and the Tax Working Group has begun to seek views on a wide variety of tax issues.

Inland Revenue has now released an Issues Paper proposing to ring fence rental losses, which is currently open for consultation until May 11. Draft legislation is likely to follow once Inland Revenue has considered the responses it receives from the public.

Taxpayers commonly derive income from multiple sources, such as salary/wages, business income, interest, dividends and rental income, to name a few. It has been a fundamental part of the New Zealand tax system that the total amount from each source, whether a profit or loss, is combined and a person is taxed on the net result.

This aggregation allows losses incurred from rental properties to be offset against other income, reducing the total taxable income and the corresponding tax liability. 

Government’s concern is that this mechanism allows property investors to take on high levels of debt to finance their property investments, which gives rise to tax losses, effectively subsidising the rental portfolio through a reduced tax liability. The high-gearing offers an advantage over owner-occupiers because their equivalent interest cost is not tax deductible.

The proposed ring-fencing rules contained within the Issues Paper seek to eliminate this advantage by preventing rental losses from being offset against other income. Instead, the rental losses will be ‘ring-fenced’ for use against future rental profits or any tax incurred on the future sale of the property. Excess losses remaining after a property is sold remain ring-fenced until rental income is derived in the future.

Labour originally indicated that ring-fencing may be introduced on an individual property basis. Thankfully, the proposed ‘portfolio approach’ is more logical, enabling investors to pool their profits and losses from all residential properties, including overseas properties, with ring-fencing applicable to any overall loss from the portfolio. If enacted, the rules will apply to all rental properties irrespective of how they are held, e.g. the rules will apply to individuals, companies and trusts.

There is complexity in the new rules because they can also impact people that don’t actually hold the rental properties. For example, if a person has borrowed to purchase shares in a company and that company uses the funds to purchase a rental property, the shareholder will normally be entitled to deduct the interest. In this situation, if 50 percent or more of the entity’s asset value is derived from residential properties the company will be classified as ‘residential property land-rich’. Amounts paid to the shareholder (eg dividends) will be classified as “rental property income” and their interest expense will be classified as “rental property loan interest”. The rental interest can only be deducted against rental property income derived from the company, or the individual’s other rental properties. Any excess loss will be ring-fenced to the person.

The proposed 50 percent asset test is an arbitrary threshold. The paper does not specifically address whether the asset values will be based on the original cost of property, or market value. While we welcome the inclusion of a minimum threshold to ensure entities with minor residential property interests are not hit with excessive compliance costs, the way in which assets are valued will need to be further considered throughout the course of the consultation.

The proposed rules rely on the existing definition of ‘residential land’, used for the purpose of the bright-line test. Thus, the rules will not apply to commercial property or property subject to the mixed-use asset rules.

The paper recognises there is a concern that taxpayers may seek to reorganise their funding arrangements to get around the loss ring-fencing rules, for example re-arranging debts against their other business interests instead of rental properties. While there is discussion of introducing a specific interest allocation rule to combat this, the paper notes that the legislation is unlikely to include a provision of this nature, as it would lead to increased complexity and compliance costs that would be particularly harsh on smaller taxpayers. 

If enacted, the proposed rules are likely to apply from the start of the 2019 – 2020 income year and in a rare move, may be phased in over a two to three-year period, something not normally seen with tax law changes. For example, only 50 percent of a person’s loss might ring-fenced in the first year. This will allow investors time to adjust to the new rules and have the opportunity to rearrange their affairs before they are adopted in full.

The comments in this article of a general nature and should not be relied on for specific cases. Taxpayers should seek specific advice.


About Author

Hayden Farrow

Hayden Farrow is a PwC Executive Director based in the Waikato office. Email: hayden.d.farrow@nz.pwc.com