Legislative changes enacted in June 2019 are now effective and will limit the amount of deductions that can be claimed against residential rental income. This change is retrospective and applies from the start of the 2019/20 income year so for most taxpayers (standard March balance date) that will be from 1 April 2019. You will probably have seen articles on this subject over the past 12 months and you may have accelerated your maintenance programme to maximise your claims prior to the commencement of the new legislation. So now what?
To recap; deductions for expenses incurred on residential rental properties will be limited to the extent of the income from that property. Any excess deductions will not be able to be offset against income from other sources eg wages or business income. The deductions that cannot be claimed (the loss that you would otherwise have incurred) are called ‘quarantined expenses’ and these are carried forward and able to be claimed against profits from the property in future.
The rules can be applied on either a property by property basis or on a portfolio basis across all of the properties in the portfolio. The default position is the portfolio basis so if you do not want to use this basis you will need to make an election in the first income tax return prepared under these rules ie for the 2019/20 year for existing residential landlords.
What’s the difference?
If you use the property by property basis, the expenses of one property cannot be offset against the income of another property. On the face of it, this does not sound like a great option. However, there is another point worth considering. If the sale of the property will be taxable (for instance due to being sold within the 5 year Brightline period) it may be worth keeping it separate because the excess deductions for that property are released on sale and can be offset against the taxpayer’s other income.
Under the portfolio basis the expenses can be offset against income from other profitable properties but there are limitations around what expenses are released on sale. Once chosen, the basis must be applied consistently from year to year.
It is also possible to have some properties kept on an individual basis and others grouped into a portfolio but note that if there is expenditure that relates to two properties (eg a loan for more than one property) the property-by-property basis cannot be used.
If the property is owned by an Look Through Company the basis applied by the LTC in filing its return will flow through to and be binding on the shareholders. This does not apply to partnerships however, and different partners may choose to apply different bases. This can become complicated if the partnership owns multiple residential rental properties.
What is ‘residential land’?
The rules only apply to residential land - defined as land that has a dwelling on it, or land for which there is an arrangement to build a dwelling on it. It does not include farmland or land that is used predominantly as business premises.
What exclusions are there?
There are exclusions for the ‘main home’, land subject to the mixed use asset rules (eg a holiday home that is used privately and rented for part of the year), land that is taxable under the existing land provisions, residential property owned by widely held companies and certain employee accommodation. The main home concept is the same as that used in the bright-line test. While this does not prevent a home owned by a trust being considered the main home, it does ensure that trust ownership cannot be used to claim multiple homes as the main home.
Other considerations
Anti-avoidance rules operate to prevent taxpayers from structuring their affairs to avoid the new rules. There are also continuity provisions which apply if the residential rental property is held in a company and care should be taken before making any shareholding changes as this may impact on the ability to claim quarantined expenses from prior periods.
The rules are complex, particularly if you own property in a variety of different ways eg personally, in a company, trust etc. We strongly recommend that you take advice before restructuring or making any changes to the way your property is owned to ensure that you do not fall foul of the new rules.
The rules are not just limited to residential land in New Zealand – their reach also extends to residential land owned overseas.
Tax Payments and Cashflow
For taxpayers who have been claiming losses from rental properties against their other income there may be a flow on effect to provisional tax. If your residual income tax (tax for the year after deducting tax paid at source) is over $2,500 you will be liable for provisional tax. If you have not paid provisional tax in the past this may result in the tax for the year (‘terminal tax’) being payable in one lump sum and the provisional tax for the next year (2021) also being due within a fairly short timeframe. This ‘double up’ of tax can cause cashflow difficulties in the first year and you should talk the options through with us if you are likely to be in this situation.
If you are already in the provisional tax system you may still need to plan ahead for the additional tax to pay, bearing in mind that while your taxable income may have increased, your actual income may not have increased at all and you could have a cash shortfall to fund.
This article is general in nature and not intended to be relied upon. Individual circumstances may differ and may affect the advice given. If you have any questions or concerns about the impact of the new rules contact BDO New Zealand for advice.