Tax Changes

posted February 02 2010

APIA feels that while much has been written by the media on the recommended tax changes, not all of the issues have been considered.

What this article is all about
These include the impact on property investors of what is recommended, what has been talked about in the past and not proposed, and what we as property investors should be doing to minimise the impact of the changes by using our collective voice in Auckland and with other PIA’s throughout New Zealand.

What are the recommended changes?
Broadly what has been proposed includes:

• A decrease in the top tax rates to 30%, and making the rate for companies, trusts, and individuals the same rate;
• An increase in GST from 12.5% to 15%;
• Removing the current deduction for depreciation from buildings that do not depreciate;
• Removing the 20% depreciation loading currently available on new residential rental chattels, and
• A land tax, or possibly a capital gains tax on property.

What is the effect of recommended depreciation changes?
The report proposes not allowing a depreciation claim on buildings where evidence shows that the buildings do not actually depreciate in value.  The report talks about that in the context of possibly having certain categories of building excluded from a depreciation claim.

The report also recommends the removal of the 20% depreciation loading on new plant and equipment that was introduced a few years ago.

This change needs to be seen in the context of what effect this would have on property investors.  An example would be a rental property purchased where the purchase price is $420,000, with land worth $200,000, the building being $200,000 and chattels worth $20,000.  If that same building had a rental of $350 per week, and had an interest only mortgage of $250,000 at 7.5% the typical result may be as follows:

	Current Scenario	Proposed Scenario
Equity in Property:
Rent received	18,200	18,200
Deductions:
Interest	18,750	18,750
Depreciation on building @ say 3% DV	6,000	-
Depreciation on chattels @ say 48% DV (including 20% loading)	9,600	8,000
Tax loss before rates, insurance etc	-16,150	-8,550
Tax to pay (or reduction) for personal investor on top tax rate of 38%	-6,137	-3,249
Tax to pay (or reduction) if top tax rate reduced to 30%		-2,565

The above figures demonstrate that the proposed changes, if implemented, would have an effect on the tax position of property investors.

The report is quite correct in some ways in saying that many buildings do not in fact depreciate.  What many investors will be aware of is that when they sell a property there is a requirement to treat as taxable income the depreciation recovered.  What this means is that if you sell and the building does not in fact depreciate, you will in effect have to repay from the sale proceeds at current tax rates the tax benefits received by claiming depreciation in previous years .  The report does not preclude claiming depreciation where buildings actually fall in value, so this change may not impact on all property investors.  It also means that if depreciation is recovered on sale and the tax rates have dropped to 30% there should still be an advantage for many taxpayers if they claimed the tax benefits at the top personal tax rates of 38% (or 39% prior to 1 April 2008).

So, in reality, this proposed depreciation change impacts on cashflow, not the investment itself.

Interestingly, there seems to be no proposal to stop any claim for depreciation of chattels which is good news for investors.

What is missing from the proposal?
A significant omission from this proposal is ring fencing tax losses.  This was talked about through 2008 and 2009 as a way of slowing down the housing market.  Using the example set out above, none of the tax losses could have been used by property investors to offset against other income and would have just been accrued from year to year if ring fencing was introduced.

To ring fence tax losses would have had far more impact on the immediate cash flow of property investors.

What about land tax or capital gains tax?
The theory behind a land tax or capital gains tax is to divert more money into the share market and the more productive export sector.

We take issue with this for all New Zealanders for three reasons:

• Land is an integral part of business – For example any land tax and capital gains tax will impact on farming, which is our biggest industry.  Inevitably if the farmer pays land tax, they will try to pass on that cost to the dairy company, which impacts in turn on the cost of dairy products.  All businesses will be affected in that commercial landlords would add a land tax as a business outgoing like they presently do for rates and insurance.  This increased rental will then cause any business owner to find ways and means of meeting this obligation by raising the cost of the goods and services produced;
• A recent government report suggested immigration to New Zealand of between 20,000 and 37,500 immigrants per annum. Private residential landlords account for 85% of rental properties.  Those migrants will need to be housed and the government clearly does not have the resources to do this.  If the tax system is used to make property investment less attractive, who will house the new migrants to New Zealand?;  
• The report also compares the $200 billion of assets invested in rental properties to the $55 billion in the New Zealand share market.  This ignores that many New Zealanders invest in Australian shares and also in financial planning investments which invest globally.  This also ignores the significant capital tied up in many privately owned businesses across the country.  The statistics provided give a distorted view of where investments are in New Zealand.

How will a land tax work?
This article focuses on land tax instead of a capital gains tax as this seems to be the preferred option in the report as it would be easier to implement.

The form of land tax proposed is an across the board tax for all types of non owner occupied property.  It would be based on the current QV system for determining rates.  The report expects that if it is introduced there would be a one off impact on property values, that is property values would decrease to reflect the value of the tax.  This is quite difficult to calculate as many rental properties are also suitable for owner occupied property on which there is no land tax proposed.

The report notes that there would be an adverse effect particularly on the retired, farmers, and Maori authorities.

An example would be a property investor who had accumulated 3 rental properties to fund their retirement.  In this case their income required for retirement would have been worked out many years earlier and the impact of a land tax could impact significantly on their retirement income.

There is discussion in the report about being able to defer the tax until death or the sale of a property to ease the burden in the short term, but this creates significant liabilities in the future.

We do not think that a land tax would be politically acceptable in New Zealand for all of these reasons, but it takes ordinary hard working New Zealanders to tell the government that they do not want this tax.

What alternatives are there to land tax or a capital gains tax?
Although the report has not proposed property ring fencing or revocation of the LAQC regime, the report does propose something much worse.  They have proposed a "Risk Free Return Method" (RFRM) of taxing residential property investment under which instead of paying tax on the actual rent received less allowable deductions, they propose to tax the owner of the property on a deemed return based on the equity they have in their investment property.  

Using the depreciation article set out above, the market value of the property is $420,000 and the mortgage is $250,000 meaning that the owner has equity of $170,000.  Under this recommendation the equity of $170,000 is deemed to return net taxable income at say 6% per annum, and so the owner would be taxed on $10,200 at their marginal tax rate each year.  

This proposal is much worse than ring fencing losses as not only is the actual cash loss not allowed to be used to reduce tax payable otherwise, the owner would be required to pay tax to IRD based on an arbitrarily deemed return.  The report suggests 6% per annum as a suitable risk free net return after expenses and before tax.  That level of net return is not easy to achieve on residential property and is certainly not "risk free" and takes no account of the many inherent risks of property investment such as vacancies and tenant damage!

The effect of the RFRM, using the same information as set out above is as follows:

 

	Current Scenario	Proposed Scenario	Risk Free Return @ say 6%
Equity in Property			170,000
Rent received	18,200	18,200
Deductions:
Interest	18,750	18,750
Depreciation on building @ say 3% DV	6,000	-
Depreciation on chattels @ say 48% DV (including 20% loading)	9,600	8,000
Tax loss before rates, insurance etc	-16,150	-8,550	10,200
Tax to pay (or reduction) for personal investor on top tax rate of 38%	-6,137	-3,249	3,876
Tax to pay (or reduction) if top tax rate reduced to 30%		-2,565	3,060

As you can see the effect of use of this alternative RFRM system to tax residential property, comes at a much greater cost to property investors.  Also, it rewards property investors who are highly geared, which seems contradictory to what the government has stated it wishes to achieve.  We note that the RFRM method is expressed as an alternative to land tax, and land tax appears to be the report's  preferred option.  

What happens next?
The government has indicated that these issues will be considered in the next budget which is in May 2010.  This creates uncertainty and in our view the sooner the uncertainly is removed the better.

What should you do as a property investor now?
We would caution against buying new rental property until the government makes clear its intentions concerning tax treatment, unless the opportunity is truly too good to miss even after factoring in the possible tax changes .  The reason for this is that a land tax would have a one off impact on property values.  Although we think it is unlikely to be introduced, if it was, the effect is likely to erode values.

In the long term we do not see that what is proposed will diminish interest in property investment as migration and population growth mean that more houses will be needed and property remains a low risk tangible investment that pays regular income for retirement and is more easily leveraged than other types of investment.

As a property investor one thing you can do is join with us and the NZPIF in lobbying government and your local MP to ask that they do not impose a land tax in New Zealand.

Do you have any questions or comments?
We would welcome any members comments and insights into what is proposed, and please feel free to email Sue Tierney at president@apia.org.nz with any questions or comments you have.
 

posted in: Finance, Capital Gains Tax , Investment Advice, Taxation

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