Thursday, April 26, 2018

Frank Newman: Ring-fencing

Inland Revenue has released an "issues paper" on ring-fencing losses. Revenue Minister Stuart Nash says the policy is an effort to "level the playing field" between speculators and investors. Feedback is being encouraged. Submissions must be in by 11 May 2018.

The policy paper says, "The proposed loss ring-fencing rules will mean that speculators and investors with residential properties will no longer be able to offset tax losses from those properties against their other income (for example, salary or wages, or business income), to reduce their tax liability.  The losses can be used in future years, when the properties are making profits, or if the person is taxed on the sale of land."

The argument being used to justify the policy is that rental housing "may be under-taxed given that tax-free capital gains are often realised when rental properties are sold. The fact that rental property investors often make persistent tax losses indicates that expected capital gains are an important motivation for many investors purchasing rental property. While interest and other expenses are fully deductible, in the absence of a comprehensive capital gains tax, not all of the economic income generated from rental housing is subject to tax. There is therefore an argument that, to the extent deductible expenses in the long-term exceed income from rents, those expenses in fact relate to the capital gain, so should not be deductible unless the capital gain is taxed."

Essentially a presumption is being made that property speculators are not caught by either the brightline test (buying and selling within five years) or the intention test, which doesn’t have a time limit and is assessed by the IRD on a case by case basis. It is also being presumed that if an investor makes a loss on a residential property then it is very likely that they intend to resell to recover all of the losses from the sale and make a capital gain.

While this will be true in some cases, there are many reasons why an investor incurs a loss from a rental activity. Quite often it is because of damage to property, unpaid rent, or vacancies. To prevent that loss being offset against other income is, in these circumstances, grossly unfair.

The ring fencing policy, as proposed, will mostly affect first time investors. Typically they have high debt, and they are most vulnerable to losses during those early years of ownership. They usually make up the loss from their day-job, and receive a tax break on the loss in the form of a tax refund.  As they repay debt and if rents rise, they will get to a position of being cash flow positive and start paying income tax on their annual rental income.

Those with more than one rental property are unlikely to be affected because the loss ring-fencing rules will apply on a portfolio basis.  The report says, "that would mean that investors would be able to offset losses from one rental property against rental income from other properties – calculating their overall profit or loss across their portfolio".

The effect is that a portfolio investor could use their existing equity as security to fully finance a new loss-making rental investment, which they could then offset against the income from their other properties, to reduce their taxable income.

Given all residential property investors who sell within five years are caught by the brightline test, there would be very few investors with resale intentions who are not already caught by the regulations. Furthermore, should the sale be outside of the brightline time limit the IRD has the power to tax any gains, if they decide resale was the intention.

Given the data-collection powers of the IRD, they will know if tax losses have been claimed prior to a rental property being sold. If the losses have arisen from high gearing, they could reasonably apply the intention test. In other words, the government already has all of the tools it needs to capture gains from the sale of property - it does not need to add yet another layer of complexity and compliance cost, although I am sure these changes will please accountants, since  what used to be very simple rental income accounts are set to become much more complex.

This looks to be a case of the politicians wanting to give the impression that they are being tough on "speculators" and the IRD is trying to make the policy work in practical terms. The effect is bad policy that will create hardship for some, while not achieving what the politicians say it will. In other words, it's bad policy.

Ironically the ring-fencing proposal further discriminates against residential property investors by creating adverse tax policies that do not apply to investors in shares, businesses, and commercial property. Not surprisingly residential property investors are now shifting their capital elsewhere, but more on that next week.

Frank Newman, an investment analyst and former councillor on the Whangarei District Council, writes a weekly article for Property Plus.

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