Two important developments occurred last week in relation to residential property.
The first development is the extension of the bright-line test from two years to five years on all residential land (not being the main family home) acquired after 29 March 2018.
The second is the release of an Issues Paper prepared by officials at Policy and Strategy, Inland Revenue and the Treasury, proposing to ring-fence losses from the renting of residential property.
Bright-Line Test extended to 5 years
The extension of the bright line test from two to five years will have a significant impact on investors in residential property.
It will seek to capture as income any realised gain on the sale of residential land (not being the main family home) which is bought and sold within five years (previously two years). This is irrespective of the taxpayer’s intention and purpose at the time they acquired the land.
The five year rule will apply to any residential land acquired on or after 29 March 2018 - the date the Taxation (Annual Rates for 2017–18, Employment and Investment Income, and Remedial Matters) Act received royal assent.
Ring Fencing of Residential Losses
The Issues Paper outlines a proposal to restrict the deductibility of rental losses arising on residential properties.
This ring-fencing of rental losses will prevent taxpayers from getting a deduction from other sources of income such as salary or wages or business income. Often the deductions arise from having a highly geared property where the interest cost of the debt used to buy the property exceeds the rental income derived.
The proposal is restricted to residential land and not commercial or industrial land. It will also not apply to:
- a person’s main home;
- properties subject to the mixed-use asset rules (such as a rented holiday home); or
- land that is on revenue account (held by a dealer, developer or builder).
The proposal is to apply the loss offset rules on a portfolio basis where losses on one rental property may be offset against rental income from other properties. The alternative would be to ring-fence the loss on a property by property basis.
Ring-fenced losses can be carried forward and offset against future residential rental income and against taxable income on the sale of residential land where the land is sold within the two or five year bright-line test.
The ring-fencing of the losses would come into effect from the start of the 2019–20 income year and could apply in full from the outset or be phased in over a two or three year period. Where it is phased in over a number of income years the proportion of loss allowed to be offset against other income would be reduced each year until no offset was allowed. A phased process may allow affected investors time to adjust to the new rules and re-arrange their affairs in an organised manner.
The ring-fencing rules will include specific avoidance provisions to stop taxpayers from structuring around the rules. For example by borrowing money to buy shares in a company to acquire residential land.
Feedback is requested in relation to the proposal to ring-fence rental losses and in particular on the proposed portfolio-based approach and whether it should be introduced completely in year one or be phased in over two or three years. Submissions close on 11 May 2018.
Both of these measures represent a significant departure from the broad base low rate mantra which has been at the foundation of our tax system for the past thirty years.
The extension of the bright-line test from two to five years will exacerbate problems with the existing two year rule. It will penalise “accidental” bright-liners. Mum and Dads who transfer their old home to a family trust to rent it out and move in to a new home. If their Trust is then forced to sell the old home within the five year period due to a change in their personal circumstances e.g. serious illness; redundancy or similar, any gain post the transfer which would ordinarily be treated as a capital gain will be taxed as income.
The proposal to ring-fence residential rental losses will create a bias in the tax system which is likely to influence decision making between the investment in different asset classes such as commercial property or a portfolio of equities.
Leaving aside the merits of the policy intent (and its efficacy on making housing more affordable) it does seem somewhat ironic that a bias against residential rental investment is being introduced independently of the Tax Working Group who are charged with reviewing the “fairness” of the NZ tax system.