The Tax Party’s Over
Property investors have enjoyed some tax perks in the past. But new rules are changing the way they’re taxed – and they’ll have to look at their portfolio differently now, says Mark Russell of PwC.
11 October 2021
Tax benefits used to be a key factor when Kiwis were buying residential property investments. They were a nice little sweetener that may give you an attractive bonus at the end of each tax year. But new tax rules that apply from this year onwards mean investors need to focus more on their pre-tax cash position when they’re working out just how attractive rental investments could be.
The ‘good old days’
In the past, if you were considering buying a rental property, you’d sensibly factor in the favourable tax outcomes when you were thinking about the economics of your investment. The gains you might make when you sold a rental property were tax-free, in most cases. You could claim a tax deduction for a wide range of expenses. This often meant your bottom line showed an overall loss on the rental for tax purposes, and that loss could be offset against other sources of income, such as salary and wages. This gave you a refund of your pay-as-you-earn (PAYE) tax that helped fund your mortgage payments.
Two law changes affect the apparent tax benefits of rental properties. 1. Investors now cannot claim tax depreciation on residential rentals; and 2. You’re taxed on gains made from selling residential rental properties within five years of buying them, for properties bought from 31 March 2018 onwards (the ‘bright-line’ rule). From 1 April 2019, important new tax rules come into force. This further reduces the tax benefits you can expect from rentals. Known as the ‘ring-fencing’ rules, these new laws stop you offsetting tax losses on rentals against other taxable income.
Here’s how it works. Kim bought a new rental property in April 2018 that earns her NZ$30,000 a year in rent. She can claim tax-deductible expenses of NZ$40,000 against that income, which includes: the interest she pays the bank on her mortgage rates insurance property management costs repairs and maintenance costs accounting services. This gives Kim an overall tax loss on the property of NZ$10,000. She also earns NZ$90,000 a year from her job. This puts her on the top personal marginal tax rate of 33 per cent. In the tax year to 31 March 2019, Kim could offset this NZ$10,000 rental tax loss against her salary. She’ll receive a tax refund of the PAYE her employer deducted over the year, of NZ$3,300. But now, with the new ring-fencing rules, Kim won’t get the tax refund. Instead, she’ll ‘carry forward’ the NZ$10,000 of excess deductions to future tax years.
Using ring-fenced deductions
Let’s say, in the year to 31 March 2021, Kim makes a profit from her rental property instead of a loss. She’s increased the rent she charges for the property, paid down some of her mortgage and decided to manage the property herself. The property also needed fewer repairs this year. She’s now making a nice NZ$5,000 taxable profit on the property for the year. She can now use that excess deduction of NZ$10,000 from 2020 against her taxable income for 2021. Kim won’t pay tax on her rental income for 2021 and she’s still got a further $5,000 of excess deductions left over to carry forward to 2022.
Let’s say, in 2022, Kim decides she’d like to sell the existing property and buy a new rental in another area. She makes a NZ$50,000 gain, which she has to pay tax on because of the bright-line rule. Kim can now use her remaining NZ$5,000 of excess deductions under the ring-fencing rules. She can offset it against profit she made on the sale of the property, so now her net taxable income is NZ$45,000. If, instead, Kim sold the property after the five-year bright-line period but still hadn’t used the $5,000 ring-fenced losses against rental income in that period, she’d continue to carry forward those losses. She can use them later, in any future tax year when she might find herself with overall taxable income from the home. But if Kim didn’t have any future residential property income, she’d never get the benefit of that $5,000 of ring-fenced losses she’d been carrying over.
Kim might buy two more rentals. Let’s say Property 1 is break-even, Property 2 makes a tax loss of NZ$3,000 and Property 3 makes a tax profit of NZ$10,000. Kim can offset the NZ$3,000 current loss and the carried-forward NZ$5,000 of ring-fenced deductions against the NZ$10,000 of profit she made, and she’ll have net taxable income of NZ$2,000.
Focus on the fundamentals
These new ring-fencing rules are important for anyone looking to buy a rental property. Investors should plan ahead and focus heavily on the pre-tax cash outcomes of any property: any losses, or profits.
Published 28 November 2019
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