Saturday, May 20, 2017

Frank Newman: Closing the speculation tax loophole

Last week Labour announced further measures to crack down on property speculators. Their latest measure is to close the "loop-hole" on negative gearing, and is the third policy statement targeting residential property investors. The other two previously announced policies would ban overseas investors buying existing homes, and extend the capital gains tax (bright-line test) on rental houses from two years to five.

To recap, negative gearing is where an investor makes a loss from their investment, and offsets that loss against other income derived from another source. The effect is to reduce their taxable income, and therefore the amount of tax they pay (based on their marginal tax rate).

For example, if a property is rented for say $20,000 a year but the expenses (typically interest, rates, insurance and repairs) total $25,000; then the $5,000 loss could be offset against their other income. So if they earn say $50,000 from wages or business income, then they would pay tax on $45,000. In this case their tax bill would fall by $1,125 from $8,020 to $6,895 which, in effect, reduces the loss from the rental from $5,000 to $3,875. According to Labour, this "loop-hole" is causing property prices to rise and making houses less affordable for kiwi families.

Although this is described as a "loop-hole", it is not a loop-hole at all. For example, it's not uncommon for businesses to spend up large on marketing during their start up phase and run at a loss. That loss may be offset against other income to gain, in effect, a portion of that spending back as a tax refund. Once the business is established in the marketplace and shows signs of turning a profit, the business could be sold for a tax free capital gain. The bright-line test does not apply as it only relates to residential property investors (ignoring the intention test which is another matter again). From a tax perspective, in this example the business would receive tax refunds during its start up phase, and the owners would make a tax free gain on the sale.

To disqualify property investors from doing the same, is not closing a loop-hole, it is actually creating a special tax penalty for residential property investors. Labour thinks landlords should be targeted, but then they probably would bring back the stocks to city malls  and subject landlords to public humiliation and tomato throwing if they thought it would advance their political cause.

Under Labour's "ring-fence" proposal, each property would stand alone for tax purposes. Losses would have to be carried forward into future tax years to be offset against future profits should there be any. This would affect all property investors, from first time property investors who typically have to borrow heavily to get a start, to portfolio investors who typically use the equity in their portfolio to borrow 100% of their next investment. 

Presumably those who own more than one rental property would have to report their annual income on a property by property basis, and pay tax on some and carry forward tax losses on others. That's an exercise that will keep accountants busy and test their creativity as they apportion interest costs between the properties.

I doubt ring-fencing would have any impact on property prices, and I doubt the additional tax revenue collected would be close to the $150m a year estimated by Labour. The use of negative gearing has been greatly reduced in recent years since claiming depreciation on residential property was removed, and interest rates are historically low. These factors have meant many landlords are paying more tax than they did previously.

I also doubt that ring-fencing will have any significant affect on house prices. What is abundantly clear is that the latest boom in house prices is driven by demand. New Zealand's population is growing by around 1.5% a year due to high immigration. These people need to be housed.

On the supply side, a free market would react quickly to the housing demand but the market has been unable to do so because of restrictive planning laws that have added significantly to land development costs. Further aggravating housing costs is a shortage of tradies and an increase in their charge-out rates as they make hay while the sun shines. Building supply companies have also been increasing prices at a time when global construction costs have been falling (eg steel).

If Labour was serious about addressing the housing shortage it should look to these areas, but then politicians are primarily interested in the politics of winning votes, and, for Labour, that means engaging in the theatre of slaying villainous landlords.


Deco fan said...

Thank you Frank for explaining how negative gearing works. You also highlight the confusion demonstrated in media reporting when the terms 'Property Investor' and 'Property Speculator' are interchanged freely. The 'slaying of villanous landlords' introduces a third term to describe presumably the same demon.
The Left will attempt to rabble-rouse by engaging the politics of envy and hate, just as the Far Right are doing in Europe. Meanwhile, back in Godzone, the foreign-based PROPERTY SPECULATORS are continuing to pump money into our housing market, double or triple it then suck it out again with no control from our rulers. It can only be deduced that our rulers, whilst crying out about the need for 'affordable housing', are in on the game.

Chris said...

In the past I have invested in the residential property market but decided a few years ago the returns were not good enough, and some tenants do not care about your property, so got out of that market and am now investing in Commercial Property which is returning a much better outcome and the tenants are usually better to deal with and cover all the outgoing cost. The sooner more residential property owners realise this then they could make better returns without the hassle of this proposed Labour tax.

paul scott said...

NZ First influence:
I think we can say that after September there will be reduction in Nett Immigration, and I think Bill Englsih will accomodate NZF here.
Second, NZF has formulated the direct intervation approach to housing, a scary business of the State building [ cheap ] houses again. I say to Denis O'Rourke " its the RMA stupid, cancel the urban boundary and Maori supremacy "
On their wish list, is some regulation on overseas buyers. These people come here without the benfit of negative gearing, I don't thnk we can get good numbersof foreign buyers because the title deeds and nominee holders obfuscate all this.
They NZF, want to rework the RMA piece by piece, instead of repealing the awful monster and replacing with new environmenntal and separate plannimg legislation. Planning legislation should be less than one page, with the default being allowance.

Brian said...

In an election year we again see that the drama of Auckland Housing has been shifted onto getting another tax imposed, this time on developers.

The real problem is that physically Auckland cannot cope with an ever expanding population, plus the majority of immigrants having to settle and work of necessity in that area. To reverse this trend and rejuvenate small towns in New Zealand is to offer a monetary solution, that will more than compensate firms and people for moving away from Auckland.

So a substantial Income Tax rebate or (lower tax bracket)for firms and working people would be a start, and a very great benefit to small country towns. The big problem is not the money but the size and scope of the inducement itself.

There are of course other problems such as the ability to build enough houses for incoming immigrants; which could be solved by houses being made to our standards; in low cost and low wage Asian countries. Then shipped out in a kitset form for erection by part semi skilled labour.

This should be no problem for our Unions to accept, after all they are very much at home in the buying of cheap Asian cars, whiteware and electronics; so why not houses to fill an unsustainable demand that we cannot overcome?

PS It surely cannot be the lack of any finance, since the Government has just subsidised Hollywood in making films in this country to the tune of millions.


Anonymous said...

I disagree with your arguments for these amongst other reasons.

1. Negative gearing is a tax loophole and is used extensively to help justify investment in residential rental properties. Attend any education session or sales promotion for rental property investment and it is regularly included in the "benefits" of that form of investment.

2. A large number of investors invest in rental property primarily in the expectation of making (tax free) capital gains. It is hard in Auckland and many other parts of NZ to justify investment in rental property investment as an economically sensible option without incorporating capital gain in the calculations. So yes, like negative gearing, it is a feature of almost every education or sales promotion session on rental property investment. Investing in rental property in almost all cases is done so with the deliberate intention of making a capital profit. The absurdity of the tax test "what was the intention of the investor when purchasing the house" and the lies and avoidance strategies adopted by residential property investors or their professional advisers around this test highlight the pretenses involved.

3. Your analogy with a business making losses and then selling for a capital profit has several flaws. The first of many reasons is there would be little or no capital profit on sale for most businesses that made a succession of operating losses. A better analogy would be that when you are selling a rental property you are selling a piece of plant or equipment of the business. Businesses have to pay tax (or claim gains) on all plant and equipment sold. Why should a house be treated any differently?

4. Usually one of the principal costs for investors in rental house investment is interest charges. It is claimed as a tax deduction. But in reality this is really payment for a capital item. If you can deduct the interest obtained for owning the capital item then the capital item i.e. the house should also fall into the same tax category. Perhaps investors could be given a choice. If mortgage interest is deducted then capital gain on sale of the house is taxable. If it is not deducted for tax then then the sale of the house is tax free.

5. To claim that the tax regime on residential property has no bearing on house price increases is nonsense. Yes immigration is a large factor but so is the tax position with residential rental property investment. It is the expectation of price increases that creates pricing bubbles. An investment offering tax free gains on price increases inevitably attracts more investors as price increases perpetuate over time. A price increase out of proportion with other parts of the economy (inflation) and with other prices internationally requires every artificial support kicked out of it.

6. Finally there is an ethical issue at the core of any tax system. Is it fair that a low PAYE taxed paid New Zealander has to try and buy his\her or their first home when competing with another New Zealander who is effectively getting a subsidy from the Government on the interest they pay if they purchase it? An investor who can obtain credit from banks at the same interest rate, or an even lower rate than the home buyer? An investor who will pay no tax on the property when they sell it? An investor who can get cheaper credit than most other businesses in New Zealand?

7. Almost every other developed economy in the World has recognised the injustice of not taxing rental property investment and have brought in capital gain taxes. It is time for this issue to be corrected. Congratulations to Labour for having the courage to begin to stand up for what is right and fair in the tax system. Home ownership is important to the economy and New Zealand for reasons other than investment.


paul scott said...

Chris [ 9.49] obviously runs a good journal ledger, and went in with more than the single aim of capital gain.
Taking Brian's [ 9.52 ] post to its conclusion, we have the scenario Tony Alexander unwittingly pointed out.
He said " we need massive immmigration of builders to build homes "
and we need them, yes " to build houses for the massive number of Immigrants "

Anonymous said...

I see this proposal of Labour's as another way to discourage investment into property and aggravating the housing shortage even more. Investors into rental accommodation should be encouraged so more houses are built.

Anonymous said...

Wouldn't it be better to concentrate on the illegal activities that take money out of the economy Meth production, instead of targeting law abiding property investors. I once heard a government promise of "three strikes and you're out" yet recently I saw that police were looking for an offender with over 60 "strikes" to his name. I wonder when he will be "out"??

Anonymous said...

RE: John's comments.

Thanks for the comments John. You traverse a number of valid areas. The purpose of my column was to point out that Labour was not plugging a loophole, but instead is discriminating against residential property investors, for political purposes.

My point is that all investment classes should be treated equally.

I did not traverse the issue of capital gains in the column, as that was not the point. I have previously written on that subject, and I have to say that I am not adverse to a universal capital gains tax system where capital gains are treated as income AND income tax rates are lowered across the board to reflect the broader collection base. That proposal, of course, loses it appeal when it becomes corrupted by politicians making exemptions to appeal to a voter constituency.

With respect to the effect on price increases, I said I do not expect Labour's ring-fencing proposal in itself will have a material impact on house prices.

I simply do not agree with your proposition that residential property investors are buying houses to incur a loss and gain a tax benefit. That's about as logical as spending a $1 to receive a 33 cent benefit. People invest in houses for many reasons, typically to build up a long-term passive income stream, or because they have little confidence in the alternatives (e.g. shares). Those who are in the business of buying and selling property for capital gain are engaged in an income earning activity and taxed accordingly. The bright line test has clarified the law somewhat when determining intention, but as noted in my column, the bright line test is discriminatory in that it applies only to residential property investors.

Fairness in a tax system, and indeed a democracy, is about treating everyone equally. There is nothing fair about politicians advancing their self-interests by casting landlords as villains and discriminating against them via the tax system. I would have thought even die-hard Labour supporters should be speaking out against that sort of vindictive behaviour.


Unknown said...

The problem of course is immigration. Stop it until the country can put in place the infrastructure to cater for it or even better stop it all together. There are going to be huge job losses in the next 10 years due to technology so we do not need more people. And second hand housing should never have been allowed to be a speculative investment. It creates nothing but misery and greed. Your house is your home and if you want a bigger one you work or invest in production and from the extra money buy a bigger house if you need one. Investment should be in production. That is if you want a successful economy.
We have a big land with a small population and are charging ourselves stupid prices for our land. We have managed to push the price of housing out of all proportion to wages and costs. The only winners ultimately are the bankers who also create nothing but debt and feathers for their nest.

Peter D said...

Well said John and Peter Caulton.
We need proper investment in production and do not need to reward property investors with a reduction of the tax on their regular income.
The burgeoning immigration rates of the last 7 years or so have benefited the property investor vastly more that the first home buyer stuck with stagnant wages and low interest rates on their savings so there is absolutely no need to advantage the property investor with a tax reduction on their income derived from negatively geared property being treated as a business.
What legitimate business can get away with a plan to generate a year on year loss and never plan to make a profit?
Australia are considering doing away with this practice and we should be too.