Property – are there really any tax advantages?
The property investment sector has been getting a hard time lately. In particular, criticism has been directed towards it by various groups reviewing or critiquing the tax system. Much has been made of the fact that, despite being an industry worth $200 billion, residential rental property owners have nonetheless recorded tax losses of $500 million.
Aspects of the Prime Minister’s speech (9 February 2010) will have been welcomed by property investors. Mr Key confirmed that there will be no land tax, and no comprehensive capital gains tax. The proposed “risk free return” method for calculating rental profits will not be implemented. However, (at this stage, unspecified) measures will be introduced to change the way that income from rental properties is taxed.
The inference is that an unfair tax system treats property investment more favourably than other investments and that skews investors’ preferences towards the property market to the detriment of other sectors. It is worth considering those claims and reviewing whether or not an investment in property really does have tax advantages compared with alternatives.
For the purposes of this exercise, a comparison will be made between investing in a residential rental property, investing in shares and investing directly in a business.
Income
Regardless of the form of investment, all income is subject to tax. For a rental property, that income takes the form of rent received from tenants. For shares, the income stream comes from dividends paid by the company. Business income is earned through the sale of goods and/or services.
Financing costs
An investor will often have to borrow money in order to fund the purchase of the income-generating asset, whether that be a property, shares or a business. In each case, the cost of interest incurred is a deductible expense. For the property investor, the cost will be mortgage interest. For the business owner, it will be the interest paid on business loans. Even the share market investor is entitled to a deduction for interest on funds borrowed to buy shares, on the basis that the shares will produce dividend income.
Cash expenses
A very broad rule of thumb is that if you have to spend money to help you earn money, the expenditure can be deducted against the income earned when calculating the tax liability. For the share investor, those costs may include management fees charged by an advisor. For the business owner, the costs will include materials, wages and overhead costs. For the property owner, the costs include rates, insurance and repairs. The rules are the same regardless of the type of investment.
Depreciation
A business owner will use fixed assets, such as machinery, computers and office equipment, to help generate income. An up-front deduction for such long term assets is not allowed. Instead, a depreciation claim can be made, based on rates set by Inland Revenue. This recognises the diminishing value of these assets over time.
The same is true for a property investor. Although land cannot be depreciated, other assets, such as appliances, furniture and carpets, can be claimed. Depreciation can also be claimed on buildings. That is contentious – mainly because buildings have generally increased in value over time. However, that is a result of the market at work; people are willing to pay increasing amounts of money for an asset despite the fact that it actually does physically deteriorate over time. A property investor is therefore allowed a tax deduction today for a notional expense that is likely to never actually materialise. What critics generally tend to overlook is that if an asset is sold for more than it’s written value, the amount previously claimed as a deduction becomes taxable income in the year of sale (“depreciation recovered”). At worst, depreciation on buildings amounts to nothing more than an interest free loan. If the evidence is that buildings do not decline in value, then there is an argument to support a depreciation rate of 0%.
Shares are not depreciable property, so no deduction is available.
Capital gains
If a business is sold for more than the book value of the net tangible assets, through the recognition of goodwill, the capital gain that is earned is generally not taxed (although any depreciation recoveries will be).
The same applies to a share investor. Capital gains earned on the sale of shares are generally not taxed, provided the investor did not acquire the shares with the intention of selling them for a profit and provided the investor is not in the business of buying and selling shares. Those with longer memories may recall that a number of investors sought “dealer” status following the share market crash of 1987.
Again, the same rule generally applies to property investors. Provided they do not buy a property with the intention of selling it for a profit and provided they are not in the business of dealing in properties, any capital gain will be tax free. In fact, the rules applying to land investments are harsher than those for other investments. That is because an investor can be “tainted” as a dealer in property because of their association with another person. In other words, a property investor may have to pay tax on what would otherwise be a tax free capital gain, not because they are in the business of dealing in property but because someone else that they happen to be associated with is.
Tax rates
The tax rates that apply to various entities (eg companies 30%, trusts 33%, individuals up to 38%) apply regardless of the activity of the entity.
Loss Attributing Qualifying Companies
LAQCs have a special tax status that allows losses to be passed through to shareholders. That has often made them the target of property investment critics.
The use of LAQCs has become so prevalent that many property investors believe that they need to use one to be able to use tax losses arising from their investment. Such claims are unfounded. Losses are able to be offset against other income even where a property is held in an individual’s name. The advantage of using an LAQC for property investment is generally limited to only a couple of specific situations. LAQCs are appropriate for situations other than property investment; simply abolishing them would be disruptive and inappropriate.
Conclusion
New Zealanders have long had a love affair with the property market. That may be due to the comfort of being able to see and touch the tangible or the perceived stability of prices. However, there are factors other than taxation that drive investment choices and it is unfair to point the finger at the tax system in isolation.
The current tax rules generally apply equally to all investments regardless of type. In some cases, that may be inappropriate, such as the case for depreciation on buildings. In other cases, property is subject to more onerous rules than that faced by alternatives, as is the case with capital gains “tainted” by association. We will have to wait until the Government delivers its budget on 20 May to find out the specifics of the changes to be made to the taxation of property. Whether that will be denying depreciation claims or ring-fencing losses, it will lead to further distortions in the way that property is taxed compared to other investments.
Further enquiries, please contact:
Geordie Hooft
T +64 (0)3 379 9580
M +64 (0)21 670 330
E geordie.hooft@nz.gt.com