Taxation of rental investment properties – understanding key recent changes

In the first of an ongoing fortnightly series, Tax Professionals looks at the key tax issues facing individuals and small business owners. Up first – we look at basic tax rules around residential investment properties and a key recent change introduced by Inland Revenue.

The first tax question to ask is whether you are a residential rental investor or a speculator/dealer in residential rental properties, as dealers are taxed more heavily.

Rental property investors who generate ongoing rental income, without any firm intent of resale, pay income tax on their net rental income but generally not on the sale proceeds of the property (exception - see Bright-line test).

Property dealers/speculators, on the other hand, who buy a property intending to sell it, have established a regular pattern of buying and selling property and must pay income tax on any gain they make from re-selling. Speculators/dealers must also pay tax on rental income.

Generally, any income received from a rental property will be liable for income tax and must be included on your tax return. There is a long list of expenses that you can and cannot claim as deductions against your rental income to minimise your tax liability.

Different tax rules for holiday homes and Air BnB’s

If your holiday home or part of your existing home is rented to the public for short-term stays, you need to be aware of “mixed-use” asset tax rules and exemptions, and how private use differs from income-earning use. There are also rules (which could save you money) around staying at the property for repair work, and rules if you earn less than $4,000 from rental in a year on the property.

Ring Fencing rules

In an effort to level the playing field between property speculators/investors and home buyers, Inland Revenue has introduced new rules to ensure that speculators and investors are no longer able to offset tax losses from their residential properties against their other income (e.g. salary or wages, or business income) to reduce their income tax liability. This legislation is known as “ring-fencing” of rental losses.

Sometimes your allowable rental expenses for your residential rental property can more than the rental income that you earned. When this happens, you are left with excess deductions. Prior to 1 April 2019, you were able to use those excess deductions to offset against any salary and wages or business income, which would have resulted in a lower tax liability – seen in the likely form of a tax refund from Inland Revenue.

Under the new ring-fencing rules, you will now need to carry excess deductions forward into the next tax year until you earn residential rental income. The new rules effectively apply to your income tax return for the year ended 31 March 2020.

There are several different methods: (i)Portfolio, (ii) Property-by-Property; and (iii) Combination, which can be relied upon to calculate your residential property income and deductions. There are advantages and disadvantages with each option that will need to be considered in light of your specific circumstances.

The rules apply differently depending on the type of entity used to own a residential property. A concession for close companies allows extra deductions in one company to be transferred to other companies in a wholly owned group of companies. Whereas deductions incurred by a partnership or an LTC are attributed to the partners/owners so excess deductions are carried forward by the relevant partner/owner.

The ring-fencing rules will mean that taxpayers will now need to track losses and profits from their residential properties to ensure that any deductions are only being claimed as allowed. Taxpayers who have claimed residential property losses in the past to reduce their net income may now also be subject to the provisional tax rules whereas previously they may not have been.

-Eshan Gupta from Tax Professionals