Ring-fencing residential property losses – legislation at last!
The changes apply retrospectively from the start of the 2019/20 income year, which is 1 April 2019 for most taxpayers. With Capital Gains Tax off the table, it would seem these rules are here to stay for the foreseeable future.
The rules apply to “residential land” in New Zealand or overseas, using the same definition of “residential land” that already exists for the bright-line test. This excludes land used predominantly as a business and farmland.
The rules do not apply to:
- The taxpayer’s main home;
- Property held by the taxpayer on revenue account i.e. land held in dealing, development, subdivision, and building businesses or bought with an intention of resale;
- Property held by non-close companies (a “close company” is broadly a company with 5 or fewer natural persons or trusts holding more than 50% of the total voting interests);
- Property already subject to the special mixed-use asset rules; and
- Property provided as employee accommodation (subject to special rules).
The default position is that the rules apply on a portfolio basis, meaning taxpayers can offset excess deductions from one residential property against income from other residential properties – essentially calculating overall profit or loss across their portfolio.
Alternatively, a taxpayer can elect for the rules to apply to some residential properties on a property-by-property basis and have others in a portfolio. Electing to apply the rules on a property-by-property basis means any excess deductions generally stay with a specific residential property.
There are advantages and disadvantages with either option that need to be considered.
Special rules prevent a taxpayer from inserting an alternative entity (e.g. a close company) to circumvent the ring-fencing by using debt to acquire an interest in the interposed entity. For example, by structuring to obtain a deduction for interest on debt used to acquire shares rather than having deductible interest subject to the ring-fencing rules because it is incurred on debt used to acquire a residential property. These rules apply when more than 50% of an interposed entity’s assets by value are residential properties.
Income that can offset excess deductions
Types of income that excess deductions can be offset against have been widened, compared to the original draft. In addition to being applied against future residential income, excess deductions can be offset against depreciation recovery income and rental income from revenue account property outside the scope of the rules (e.g. property held on “revenue account”), subject to special rules.
Rules apply differently, depending on the type of vehicle used to own a residential property. For example, excess deductions carried forward by a close company are subject to the continuity rules that apply to losses incurred by companies. A concession for close companies allows excess deductions in one company to be transferred to other companies in a wholly owned group to be offset against residential income in that other company. Whereas deductions incurred by a partnership or a look-through company are attributed to the partners/owners so excess deductions are carried forward by the relevant partner/owner.
The legislation is not entirely clear as to how the property-by-property election applies to look-through entities i.e. partnerships and look-through companies. Our understanding is that a look-through entity will make its own decision whether to apply the rules on a portfolio or property-by-property basis, with that decision being attributed to the owners/partners i.e. a share of any portfolio held by a look-through entity will be added to the portfolio (if any) which is held by the owner/partner. We expect this will be clarified by Inland Revenue shortly.
Further points to note
The ring-fencing rules means taxpayers will need to track losses and profits from their residential properties to ensure any deductions are only being claimed as allowed.
Taxpayers who have claimed residential property losses in the past to reduce their net income may now be subject to provisional tax rules, when previously they may not have been. This means some taxpayers, who, in the past would have expected a tax refund, may be disappointed in the future.
As always with new legislation, the devil is in the detail. It is crucial to work with your accountant to evaluate your rental portfolio performance and ensure you are not disadvantaged - or at the very least, not surprised