People derive income from multiple sources, such as salary / wages, business income, interest, dividends and rental income. It is a fundamental feature of NZ's tax system that a person is taxed on their total income from all sources, whether a profit or loss.
This aggregation allows losses incurred from rental properties to be offset against other income, reducing a taxpayer's total income and corresponding tax liability. The Government's concern is that this mechanism allows property investors to take on high levels of debt to finance their property investments, giving rise to tax losses, effectively subsidising the rental portfolio through a reduced tax liability. The high-gearing offers an advantage compared to owner-occupiers because their interest cost is not tax deductible.
The proposed ring-fencing rules contained within the Issues Paper will eliminate this advantage by preventing rental losses from being offset against other income. Instead, rental losses will be 'ring-fenced' and offset against future rental income, or any tax incurred on the future sale of the property.
Labour originally indicated losses might be ring-fenced by individual property. Thankfully, the proposed 'portfolio approach' is more logical, enabling investors to pool their profits and losses from all residential properties, including overseas properties. If enacted, the rules will apply to all rental properties irrespective of how they are held, i.e. the rules will apply to individuals, companies and trusts. The proposed rules also use the existing definition of 'residential land'. Thus, the rules will not apply to commercial property or property subject to the mixed-use asset rules.
There is complexity in the new rules because they can impact people that don't hold 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 interest incurred by the shareholder is normally tax deductible. In this situation, if 50% or more of the company's asset value is derived from residential properties the company will be classified as "residential property land-rich". Amounts paid to the shareholder (e.g. 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, with any excess loss ring-fenced to the person.
The application of the proposed 50% asset test is currently unclear – the issues paper does not indicate whether it will be based on market value or historical cost. This will undoubtedly be addressed during the consultation period. If enacted, the proposed rules may be phased in from the start of the 2019 – 2020 income year. This will allow investors time to adjust to the new rules and provide the opportunity for taxpayers to rearrange their affairs before the rules are adopted in full