News
Buying a Rental Property – tax issues to consider
Posted: 02 November 2009
Introduction
Around $200 billion is invested in rental properties in New Zealand. With interest rates at levels that have not been seen for 40 years, this will only see increased numbers of investors purchasing property to hold as a rental investment. I have been asked by numerous clients and family friends both how they should hold a rental property and to advise on any risk areas to watch out for.
Calculation of income
A major advantage of property investment is that, in general, the gain on sale is not taxable. As a rental property is deriving income, costs that are connected to the derivation of the rental income will be tax deductible. The major categories of expenses that a rental property investor can claim are as follows:
Interest charges
If a mortgage is used to purchase the property interest payments made to the bank will the tax deductible. The repayments of the loan principal are not tax deductible.
Depreciation
A property investor can claim depreciation on the building and its chattels (e.g. dishwasher or curtains). Previously, landlords were splitting a building into separate components (e.g. internal walls, wiring and plumbing). This allowed higher depreciation rates to be used on the separate components rather than depreciating the entire building at the much lower building depreciation rate. Inland Revenue has published a media release advising that it is unacceptable to split out such assets that are attached to the building.
Legal costs
Legal fees for arranging the finance and lease documentation are deductible. The legal fees connected with the purchase of the property are not deductible. However, these can be capitalised to the cost of the property and depreciated accordingly.
Repairs and maintenance
Costs to repair and maintain the property are tax deductible. However, if the work improves the property to a condition better than before the work, the work becomes capital in nature and is therefore not deductible. Capital improvements must be depreciated at the applicable depreciation rate.
The deductibility of substantial work undertaken to fix a leaky building may not always be clear cut and you should discuss this further with your advisor.
Other costs
Other costs that will generally be deductible include accounting fees, advertising for tenants, property management fees, bank charges, insurance, mileage on your vehicle used to inspect the property, council rates and ground lease if the property is on lease hold land.
At the end of each financial year you will prepare an income statement showing the total rental income less all deductible expenses. This will result in either net income or a loss. Rather than generating a net income result as you would expect from a successful investment, New Zealand rental properties provide a disappointing tax yield – currently $150 million in tax losses are generated each year that are being offset against other income (this is discussed further below).
Ownership
Both your family circumstances and also whether you expect your rental property to derive net income or a loss will be significant factors in determining what type of ownership vehicle you chose to hold the property in. A majority of New Zealanders will hold a rental property in one of three ways:
- Personally (i.e. in their own name); or
- In a company (including a loss attributing qualifying company); or
- In a trust.
The issues around using these structures are discussed below:
Personally
This is when the property is held directly in your own name, or in the names of a partnership (the other partner probably being your spouse). The net rental income or loss is received directly in your name and is therefore taxed along with other income you have earned.
If the property is held jointly the net profit or loss for the year will be divided equally between the couple and included in their personal income tax returns. It is not correct to pass the full profit or loss to only one of the partners if the property is held jointly. This raises some points to consider:
- Where the property derives a rental loss and one of the partners derives a significantly larger salary (i.e. paying tax at the higher tax brackets) than the other partner, if the rental property is owned by the higher salaried earner only, there is larger benefit than simply sharing the tax loss between the partners.
- If the property derives a rental profit, you could consider whether the lower income partner can own the property as this will ensure income is split between the partners therefore minimising the overall group tax payable.
Tax considerations are not the sole commercial consideration to structuring an investment and will need to be weighed up against other issues such as matrimonial property considerations etc.
This form of ownership has the benefit of not requiring the formation of a company or trust to hold the property. However, this option does not allow for income splitting to other family members other than discussed above.
Company
A company is a vehicle that has been incorporated and registered with the Companies Office. It is a separate legal entity from its shareholders. There will be more compliance costs to using a company than holding the property personally. An annual return needs to be filed with the Companies Office, as well as the preparation of financial statements and a separate income tax return.
Companies generally have the disadvantage of not being able to transfer a tax loss generated on the rental property to its shareholders. Accordingly, if there is no other income generating assets in the company to soak up the losses they will simply sit in the company until they can be used at some point in the future.
However, this can be overcome by electing to Inland Revenue that the company become a loss attributing qualifying company (LAQC). There are certain criteria that the company must satisfy to become a LAQC, however satisfying this should be relatively straightforward for a family owned company holding a rental property and any other minor New Zealand investments.
Any tax losses the LAQC incurs are passed directly out to shareholders in proportion to their shareholding and can be offset against other income that the shareholder earns. There is however a requirement for shareholders of a LAQC to personally guarantee the company’s tax liabilities, if any.
Trust
Trusts are also often used to hold rental properties. One major benefit is that the trust can quarantine the property investment from other business activities.
Another major advantage of a trust is that it allows income to be split. Income can be passed to not only the husband and wife, but also to children or grandchildren of the family provided they are beneficiaries. This can assist to reduce the overall family tax bill. However, if the rental property generates a tax loss this cannot be distributed to the trust’s beneficiaries. To soak up the tax losses in the trust, income generating assets (e.g. a term deposit or another rental property generating net income) will need to be used.
As with companies, there are some compliance costs on initial formation and for preparation of annual financial statements and a separate income tax return.
Selling the property
It is likely given the situation over the past 20 years, that when you sell the property it will be at a price higher than what you paid for it. This means that you will have recovered some (or possibly all) of the depreciation that was deducted and you will therefore have to pay tax on that depreciation recovered. In other words, a property investor should see the claiming of depreciation as deferring income rather than permanently deducting it. This can result in a large unexpected tax bill. You also have the option to elect not to depreciate the building if you expect your income to increase substantially over the next few years and you envisage selling the property during this time.
With this in mind, you should consider maximising to the greatest extent possible (i.e. within the confinements of the law) other deductions that are not recovered as income on the sale of the property (e.g. repairs and maintenance and vehicle mileage costs).
Transferring the property or changing the use of it
If you live in the house and later decide to move on and rent the house, there are rules upon transferring the property to a company or trust. The sale will be to an associated party and must therefore be at market value in order to avoid negative tax consequences.
Even though the cost of the property may have been stepped up due to the sale being at market value, there are depreciation restrictions that apply meaning that the tax depreciation rate applied by the purchaser cannot exceed the rate that had been applied by the vendor. Further, the purchase price on which the depreciation is calculated is deemed to be the lesser of the cost of the property to purchaser or vendor.
If you decide to move into a property that you previously rented out, there is a deemed sale of the property and as discussed above you are likely to have a tax bill as a consequence of the depreciation recovery income. It is not recommended that you continue to claim that the property is rented out and therefore continue to claim tax deductions for expenditure if you rent the property to yourself as Inland Revenue may query this as a form of tax avoidance.
