Loss ring-fencing has gone back to the drawing board

6 May 2019

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After feedback from Chartered Accountants, landlord groups and others, we’ve heard from IRD that they’ve thrown out the draft legislation (in late April) and are starting from scratch.

This legislation was to apply from 1 April – it was retrospective in nature, and now it’s up in the air.

Don’t be fooled though – loss ring-fencing will still be brought in (we’d be surprised if it didn’t). The detail around it will though.

A recap – what is loss ring-fencing?

Say your current residential rental property runs at a loss of $10,000 each year. That is, the rent doesn’t cover the expenses on the property and you’re covering the rent shortfall.

Currently you can offset this loss against your PAYE or other business income. This in turn generated a tax refund of $3,300 for most people.

The losses usually arise from the property being negatively geared, and in some cases from doing significant repairs (like repainting) on a property.

Why they’re starting again?

In short, they’ve thrown out the rules proposed because the initial draft was fundamentally flawed. Many of the flaws in the initial draft were technical in nature. Without bogging you down in the detail, the draft was exceptionally long-winded (for lack of a better term) and used inconsistent terminology (they mixed up apples and oranges).

The initial draft also didn’t achieve what they wanted it to achieve. For example, you might take two loans to buy a rental property, one in your personal name and one in a company name. The new rules would have applied to the company loan, but not the personal loan.

Further, there were significant issues where rental properties were refinanced in a particular year, where a company sold a rental property, and the reporting requirements for builders became onerous. We could go on about mixed residential/commercial properties not being allowed for, depreciation becoming an issue (again) and so on – we’ll be here all day.

In short, when the legislation came out, the Government weren’t interested in changing the legislation. However, and thankfully, they’ve revised this position and have started again with the legislation.

What we expect to change?

To be honest, we expect very little to change with the redraft. In fact, it will likely be tighter in nature. The original draft had numerous loopholes in it. Those loopholes will likely be tightened.

The legislation will also be better drafted. This means the laws will apply more consistently, with fewer shades of grey.

What could change is the application date. IRD and Treasury advice was clear – the legislation should be phased in over a number of years. Whereas, the draft legislation had the new rules applying in full force from 1 April 2019.

Given that the final legislation will not be available for a number of months, it may be difficult to backdate. They (we hope) will also take the IRD and Treasury advice on-board and phase in the introduction.

Why phase in the application date?

Here’s the thing. The new rules fundamentally change the finances of some people owning rental properties. For some, the rental is their sole form of retirement savings. To have the new rules apply in full force from 1 April, without having finalised legislation available, is a little unfair (for lack of a better word).

This legislation was to apply from 1 April – it was retrospective in nature, and now it’s up in the air.

How should you plan for the introduction of the rules?

The thing with loss ring-fencing is that it only applies if your rental property portfolio is making a loss. So, if you’re making money from your rentals then the rules have no impact whatsoever.

In fact, if you’re an established landlord then the rules may help. New investors won’t get the tax breaks you’ve had, reducing competition in the auction room when buying a new property.

The game with loss ring-fencing becomes one of building a profitable rental portfolio. This means balancing your portfolio with loss-making properties (with higher capital growth) against revenue making properties (with lower growth). Put another way, have a mix of properties—for example have the loss from a high growth property in an inner-city suburb balanced against the high yield from an apartment.

We can help you understand the options – just get in touch.

Should I sell my rentals?

No. If you’re selling your rental just because of a change in tax rules then you’re likely selling for the wrong reason. There’s a reason you bought the property, beyond just a tax refund.

At the same time, if your cash is stretched by the change then weigh your options carefully. Most people lose money selling in a time of financial distress.

Should I increase the rent I charge?

Potentially, subject to the rental market in your area. Ultimately, you’re carrying a bigger share of the rental cost, and that needs to be picked up by someone – either you or the tenant.

Should I restructure my portfolio to mitigate the new rules?

Potentially, but, it’s important to weigh up the impact of the new five year Bright-line test. This means if you buy and sell a rental within five years then you’re caught by a capital gains tax.

Expert tax advice should be sought before undertaking any property transaction.

We’re always happy to help – get in touch for an initial no obligation discussion.

Your tax payments

If you’re currently a provisional taxpayer, we’re recommending making provisional tax payments based on the losses not being available.

If you’re using a special tax code certificate we’re recommending not using it.

The worst case from taking this approach is you pay the right amount of tax. Best case they delay the introduction of the new rules and you get a tax refund.

What’s next

Many of our successful investors are working out the profit on a property-by-property basis. They’re then working out what rents would need to move by to counter the impact of loss ring-fencing.

This gives them a baseline to work from.

It’s then a question of working out the optimal mix in properties – high growth compared to high yield. Put another way, the mix of properties which increase in value, versus those which give a high rent return.

If you’d like to discuss this more, then please get in touch.

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for more help feel free to reach out. Get in touch with Hamish Mexted