Earlier this year we issued a Tax Alert setting out proposed tax changes that would preclude residential property investors from offsetting residential property losses against their other income (for example, salary/wages or business income).
The legislation enacting the ring-fencing rules received Royal Assent on 26 June 2019, and will apply retrospectively from the start of a person’s 2019/20 income year – so from 1 April 2019 for standard 31 March balance date taxpayers.
Overview
The rules apply to “residential land” (in NZ or overseas), using the same definition of “residential land” that already exists for the bright-line test. This excludes land used predominantly as a business and farm land.
The rules do not apply to:
- The taxpayer’s main home;
- Property held by the taxpayer on revenue account (i.e. it is land held in dealing, development, subdivision, and building businesses or was bought with an intention of resale);
- Property held by Government enterprises;
- Property held by non-close companies (a “close company” is broadly a company with 5 or fewer natural persons or trusts holding more than 50% of the total voting interests);
- Property already subject to the special mixed use asset rules; and
- Property provided as employee accommodation (subject to special rules).
The default position is that the rules apply on a portfolio basis, meaning that taxpayers will be able to offset excess deductions from one residential property against income from their other residential properties – essentially calculating their overall profit or loss across their portfolio.
Alternatively, a taxpayer can elect for the rules to apply to some residential properties on a property-by-property basis and have others in a portfolio. Electing to apply the rules on property-by-property basis means that any excess deductions generally stay with a specific residential property.
There are advantages and disadvantages with each option that will need to be considered in light of your circumstances.
Special rules will prevent a taxpayer from using an interposed entity (e.g. a close company, a partnership or a look-through company) to circumvent the ring-fencing rules by using debt to acquire an interest in the interposed entity. For example, by structuring to obtain a deduction for interest on debt used to acquire shares rather than having deductible interest subject to the ring-fencing rules because it is incurred on debt used to acquire a residential property. These rules apply when over 50% of an interposed entity’s assets by value are residential properties.
Income that can offset excess deductions
The types of income that excess deductions can be offset against has been widened compared to the original bill. In addition to being applied against future residential income, excess deductions can be offset against the following types of income :
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Depreciation recovery income;
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Rental income from revenue account property outside the scope of the rules (e.g. property held on “revenue account”), subject to special rules.
Structuring
The rules apply differently depending on the type of vehicle used to own a residential property. For example, any excess deductions carried forward by a close company are subject to the continuity rules that apply to losses incurred by companies. A concession for close companies allows excess deductions in one company to be transferred to other companies in a wholly-owned group to be offset against residential income in that other company. Whereas deductions incurred by a partnership or a look-through company are attributed to the partners/owners so excess deductions are carried forward by the relevant partner/owner.
The legislation is not entirely clear as to how the property-by-property election applies to look-through entities – i.e. partnerships and look-through companies. Our understanding is that a look-through entity will make its own decision whether to apply the rules on a portfolio or property-by-property basis with that decision being attributed to the owners/partners – i.e. a share of any portfolio held by a look-through entity will be added to the portfolio (if any) which is held by the owner/partner. We expect that this will be clarified by Inland Revenue in a Tax Information Bulletin explaining the new rules, which is expected to be released in September 2019.
Further points to note
The ring-fencing rules will mean that taxpayers will now need to track losses and profits from their residential properties to ensure that any deductions are only being claimed as allowed. Taxpayers who have claimed residential property losses in the past to reduce their net income may now be subject to the provisional tax rules whereas previously they may not have been.
As always with new legislation, the devil is in the detail.
An update on Ring-Fencing Video
The above video provides an overview of the new loss ring-fencing rules applying to residential property. This includes an explanation of when the rules apply, what the rules apply to, how the rules apply on a portfolio basis or property-by-property basis, some special rules applying to interposed entities, and what income can be used to offset any excess deductions that are suspended under the new rules.
Please contact your usual BDO adviser if you have any questions about how the new rules will apply to you.