Sunday, January 24, 2010

Mike Butler: Losing money on rentals

Property investors who offset rental losses against personal income would be surprised to find out that the Tax Working Group has not prescribed measures on loss attributing qualifying companies.

Possibly Prime Minister John Key’s comment about “closing loopholes” has sparked debate, especially among commentators who have been campaigning against these companies.


The fact that Mr Key and Finance Minister Bill English have also said they would study the report closely seems to indicate that some action is forthcoming, especially when compared with their reaction to the Brash 2025 Taskforce report, which they ruled out as too radical.

The working group does mention LAQC losses, noting “a marked decline in net rental income since 1999 (has been) accentuated by losses claimed through loss attributing qualifying companies (LAQCs).

A LAQC is a normal company with a special tax status that enables losses to be offset against the shareholder’s personal income for determining their tax liability.

Before the working group report was released, some property accountants had suggested “ring-fencing” property losses, so that rental losses could only offset against rental profits.

The report said that “a consequence of the tax treatment of rental property investment is that the $200-billion investment in rental housing generated net rental losses totaling about $0.5-billion and approximately $150-million in tax revenue losses in 2008”.

The report also noted that 9700 families with rental losses receive Working for Families tax credits.

The report does not specify the extent of LAQC losses. However, figures obtained from the Inland Revenue Department by interest.co.nz show the value of tax losses claimed by LAQCs in 2008 was $2.258-billion. This was more than triple the losses claimed before the housing boom began in 2003.

At least 40,000 LAQCs were registered with the IRD, where the stated LAQC activity included property. About 130,000 LAQCs filed returns for the year, according to interest.co.nz.

My view is that a rental property that loses money every week is not an investment. It is the opposite of an investment.

If the interest, rates, insurance, and maintenance costs exceed the rental income, every week that hapless landlord must top up his rental account with money from elsewhere, usually his or her wage or salary. How much do you want to pay every week for your loss-making rental?

That loss is credited by the IRD by way of a rebate on tax paid on the day job.

The problems with negative gearing, as this loss-making approach is called, are: Who pays the outgoings when the rent is not paid, when there is a vacancy of a week or more, where does the money come from when there is damage to repair?

Worse, what happens if the day job disappears? The newly unemployed landlord can’t pay for repairs, can’t pay the insurance, a rates demand is missed, can’t pay the mortgage, and after a series of terse letters from the bank, the property goes to mortgagee sale.

Now an even bigger problem looms. What if the government ends the ability to offset rental losses against personal income?

Numerous properties bought as rentals during the property boom were loss-makers from day one. An experienced investor would not even need to pull out the calculator to see that that cost of the mortgage would exceed the expected rent on properties that should have been sold to first-home buyers. I have seen property gurus, real estate salespersons, accountants, and lenders encourage naïve mums and dads into these dud investments.

I imagine the recession has already cost the jobs of a number of investors stuck with a loss-making rental.

If the Key government intends to close the LAQC loophole, advance warning is needed so that those affected may reorganise their affairs. This would give the investor time to pay off a chunk or mortgage so the property is profitable, or sell the property.

If the change is sudden, a whole lot more are going to be burned.

References:
A Tax System for New Zealand’s Future, Report of the Victoria University of Wellington Tax Working Group.
http://www.victoria.ac.nz/sacl/cagtr/pdf/tax-report-website.pdf/

LAQC losses tripled to NZ$2.3 billion between 2003 and 2008 http://www.interest.co.nz/ratesblog/index.php/2009/09/08/laqc-losses-tripled-to-nz23-billion-between-2003-and-2008/

5 comments:

Anonymous said...

You are right... negatively geared property investors are going to face a massive problem if some or all of the proposed changes take effect. Land values will fall, and they will lose the cash flow benefits of being able to off-set their losses. This will no doubt force some to the wall, as will be reflected in the number of mortgagee sales. National is doing to landlords what the lange government did to farmers in the 1980s.

Muriel Newman said...

Deleted by mistake!

I see the Green Party are offering to support a land tax and the Maori Party probably would if Maori land is excluded. So National would have the numbers to pass it if they wanted to! Do you think National will go for it?

Mike Butler said...

Easy to support a land tax if you own no land or are excluded from the tax. More difficult to back measures that will make one worse off -- nobody is that altruistic. Would the National Party support a land tax if all farm land was excluded, thus protecting a part of their support base? Then there are the big business supporters heavily into commercial property -- so I guess commercial property would have to be excluded to protect National Party supporters. It all gets rather murky rather quickly.

Anonymous said...

It is surprising that ring fencing of LAQCs was not mentioned in the Tax Working Group report. Reversing the LAQC legislation would have been an obvious and quick way to plug a $100m tax hole in the dyke.

Anónimo said...

I have to say that I am not entirely sympathetic to people in this situation. When buying a property, one should always think about the cashflow i.e. is it going to make money now. There are lots of people who bought expensive properties with dreadfully low yields expecting that prices would continue to skyrocket, assuming that rental incomes will appreciate in future to make things worthwhile. Also, when one buys a rental property, one should consider the surplus cashflow i.e. can they afford things like a rise in interest rates. These investors are in a mess they created.