After you buy your first home and accumulate some equity in it it may be time for you to climb up the property ladder further. Now, when you are ready to start investing it is extremely important to do it right from the beginning. And the first question that needs to be asked is what legal structure to choose and what tax consequences it will bring.
Recently, The Taxation (Annual Rates for 2019–20, GST Offshore Supplier Registration, and Remedial Matters) Act 2019 has been enacted. It introduced ring-fencing rental losses, a new rule for New Zealand residential property investors that will apply from the beginning of the 2020 financial year, i.e. from 1 April 2019.
To keep it simple here is what it means for property investors:
- If expenses related to your rental are higher than your rental income you can not reduce your other income by the amount of your rental loss.
- You can use that loss amount against the profit from your rental – in a tax year when it gets profitable. Before this happens, ring-fenced losses can be accumulated.
- The amount of ring-fenced losses can be used to reduce or even nil taxable gain on sale of property for example if a rental is bought on or after 29 March 2018 and sold within five years after the purchase (so called the bright-line test). Unutilised ring-fenced losses can be used in future when an investor buys another rental.
- An investor can elect to apply the rules on a property-by-property basis or on portfolio basis. This means that if an investor has got more than one rental, they can choose to track their ring-fencing losses by property or by the whole portfolio. Also, there is an option for an investor to include some of the properties to the portfolio and keep the others separate.
- Ring-fencing losses rules do not apply to your main home, business premises, commercial property, farmland, mixed used assets, employee accommodation, property bought as part of a land dealing business or bought with the intention of resale
This is the minimum that every investor may want to know about the new legislation. Now let me come back to the main question: what structure will suit better a new investor in the changed tax environment?
- The first and simplest structure to be used is to buy a rental under a natural person’s name. If you get profit from your rental it is going to be taxed at your marginal rate. If you get a loss then the new rules will apply and you can offset the loss against your future profit.
The biggest disadvantage of this business structure is that even though it looks like a cheap option in reality it may appear that it is the most expensive one. Rental property under your personal name is not separated from your other assets. This means that has no protection against your creditors and relationship property claims. Also, under some circumstances the process of inheriting this property may get complicated.
- Another option is to set up a trust and transfer your residential property to this trust. It can by a costly and time-consuming option since proper trust setting and running implies that you will need to work closely with your financial adviser, lawyer and an accountant. However, it may be worth it: your property will be kept secured and protected against claims by creditors and ex-spouses / partners. Assets kept in trusts will be inherited by the people you want, and not the people that persuade the court that they were disadvantaged.
Taxwise, if the trust makes a profit out of rental property it may keep that profit in the trust or distribute it to the beneficiaries. If the profit is kept in trust it should be taxed at the flat rate of 33%. If it is distributed to the beneficiaries, it will be taxed at the beneficiaries’ marginal rates except for children under 16 (for them, the rate of 33% applies).
If the trust makes a loss it is subject to the above-described ring-fencing losses rule. The loss cannot be distributed to the beneficiaries and cannot be offset against other income that the trust may have.
- There is an option for you to create a limited liability company and transfer your rental to the company. It will help you protect your property better than if it was held by a natural person but not as well as if it was held in a trust. However, the tax consequences will be similar. If profit is held in the company it will be taxed at the flat rate of 28%. If it is distributed to a shareholder as a shareholder salary it will be taxed at their marginal rate. Ring-fencing losses rule will still apply to the company losses.
There is one minor exception from this rule. As per s EL 11 of The Taxation (Annual Rates for 2019–20, GST Offshore Supplier Registration, and Remedial Matters) Act 2019, if a company is not a close company, i.e. has got more than six not associated natural persons, the ring-fencing losses rule does not apply. However, the majority of New Zealand companies are close companies and will be still caught by the new rule.
Nowadays due to the implementation of ring-fencing losses legislation, holding rental properties individually or keeping it in a trust or in a close company will not differ significantly in regards of tax. Each ownership structure allows distribution of profits to individuals and tax at individuals’ marginal rate. However, the losses will be still subject to the new rules.
Therefore when choosing a business structure, it is worth considering other pros and cons such as security, compliance costs and accessibility of profit.
The article is written by Valiya Gafarova, Certified Xero Adviser and Accountant at GECA Chartered Accountants. If you want to know more about tax consequences of having a rental feel free to get in touch with us on 0800 758 766.
Please note that this blog post should be considered as a general overview but not as a tax advice relevant to your situation.