What does ring-fencing of rental losses mean?
This means that investors are no longer able to offset residential property losses against their other income (for example, salary or wages, or business income), to reduce their overall tax liability. To the extent the residential rental deductions exceed the residential rental income, any residential rental tax losses will be carried forward and offset against residential property income in future years until they have been fully extinguished.
What does the rule apply to?
The rules apply to “residential land”, which is currently defined under the bright-line test.
“Residential land” means:
- land that has a dwelling on it.
- land there is an arrangement to build a dwelling on; or
- bare land that, under the relevant operative district plan rules, may have a dwelling built on it.
However, even if one of these criteria is met, the land is not residential land if it is:
- used predominantly as business premises; or
“Residential land” is not limited to land in New Zealand – it extends to overseas land. This was considered appropriate for the bright-line test, and the same approach is taken for the ring-fencing rules.
What does the rule not apply to?
- the taxpayer’s main home
- property subject to the mixed-use asset rules
- property that will be taxed on sale (subject to notification requirements for some taxpayers)
- property owned by companies other than close companies
- employee accommodation, and
- Government enterprises
What is residential portfolio?
Investors may elect to apply the residential property loss ring-fencing rules either on a portfolio basis or on a property-by-property basis.
Portfolio basis is the default basis. This means investors calculate their overall profit or loss across their residential rental portfolio. The income from all properties in the portfolio is offset by deductions for all properties.
However, investors elect to apply the rules on a property-by-property basis if they wish. When using the property by-property approach, each property is looked at separately and deductions for one are not able to offset income from another.
If the property-by-property approach is taken, and it transpires that the sale of the property is taxed, any remaining excess deductions are released from the ring-fencing rules and used against the taxpayer’s income from other sources.
Structure for residential rentals
There are various structures available to own residential rental investments. These structures include a natural person, a closely-held company, a trust, a look-through company, and a partnership.
In brief, these are companies with five or fewer natural persons. For these companies, any unused excess deductions under the ring-fencing rules are subject to the existing shareholder continuity rules for companies with any unused rental tax losses being ring fenced from other operational unused tax losses. If the shareholder continuity requirements are breached, the amount of unused excess deductions that are allocated to the relevant income year may be lost.
Furthermore, some or all ring-fenced deductions can be transferred between companies in a wholly owned group. The ability to transfer ring-fenced deductions is limited to companies in the same wholly owned group, as the economic ownership is the same in both entities. Transferred deductions remain ring-fenced, so can only be used against “residential income” derived by the transferee company.
If a trust makes a profit from its rental property investments, the trustees may elect to either keep that profit in the trust, or distribute it to the beneficiaries. If the profit is kept in trust, it will be taxed at the flat rate of 33%. If it is distributed to the beneficiaries, it will be taxed at the beneficiaries’ marginal rates. The only exception to this rule is that any income distributions made by a trust to children under 16 will be taxed at a rate of 33% instead.
If the trust makes a rental loss, it is subject to the ring-fencing losses rule. The rental loss cannot be distributed to the beneficiaries and cannot be offset against other income that the trust may have.
Look-through company (LTC) or a partnership
Deductions incurred by a partnership, or a look-through company, are attributed to the shareholders/partners so excess deductions are carried forward by the relevant shareholders/partners.
Author – Sammi Sutherland