Henderson Reeves Auckland

New Tax law impacts residential property investors

In this guest article, Andrew Nicol, of Opes Partners, reviews what these changes mean for property investors and landlords in regards to structuring their portfolios.
Optimising your portfolio's structure means you'll be able to keep more of your money.

Why Structure Your Portfolios in The First Place?

The reason accountants and lawyers consider the best way to structure assets are so they can:

  • limit the amount of tax you have to pay, which saves you one of your most significant costs (tax)
  • protect your assets from other people attempting to take control of them, e.g. former and current partners.
  • Optimising your portfolio’s structure means you’ll be able to keep more of your money.

How property investors behaved before the Ring Fencing legislation passed

To invest in the NZ property market, many Mums and Dads leverage their own home to fund their deposit. Leveraging their home means they are effectively borrowing 100% of the purchase price to invest.

Because they are borrowing a higher amount than if they had used a cash deposit, interest payments are correspondingly higher. Along with the other expenses of owning a rental property, this frequently means the investments make a small cash loss each year.

Once depreciation is factored in, we frequently see investments make taxable losses in the vicinity of $12,000.

Before the Ring Fencing legislation passed, investors could hold their properties in a Look Through Company (LTC). Using an LTC meant that these losses could offset their personal income tax. Under the previous rules, property investors could frequently claim a tax credit each year.

To show you how this worked: say an individual had a salary of $100,000 and a property earning a taxable loss of $12,000. Rather than paying income tax on their $100,000, they would only need to pay tax on $88,000 (the difference between the two).

The investor could then claim back the tax already paid on the extra $12,000 of income. In this case, that’s about $4,000.

Using this structure could turn a property with negative cash flow into a property that had a small cash surplus. Or, otherwise, decrease the contribution an investor would need to make to top up their properties account (in this case about $80/week).

 

The ability to offset these losses meant there was an advantage to holding negatively geared properties in an LTC, as opposed to a Trust.

 

That advantage occurred because when you hold properties in a trust, you are no longer the legal owner of the asset. Because of that, any losses the properties incur are effectively ring-fenced within the trust.

Under the previous tax system, there was also an incentive to hold positively geared properties in a separate entity to negatively geared properties.

Holding them together would limit the taxable loss you could claim against your income, meaning you couldn’t claim as much tax back.

How the legislation impacts how investors structure their portfolios

There are two key ways this legislation affects how property investors structure their portfolios.

1) Trusts have become more attractive

The passing of the legislation means there is less incentive to hold properties within an LTC. Your losses will be ring-fenced whether you keep your properties in a trust or an LTC.

Investors should consider whether a trust is a more optimal structure for their portfolio, as opposed to an LTC. That’s because a trust typically provides more protection of your assets than the alternative.

 

As mentioned when you use a trust, you are no longer the legal owner of the assets. That separation offers you protection if you default on a personal guarantee or have relationship property disputes, for example.

2) It’s better to hold assets in the same entity

The government has taken a portfolio approach within the legislation. If you have a property that makes a profit, you can decrease the tax you pay. The way to do this is by holding it in an entity with a negatively geared property.

That is the exact opposite approach to what we would have previously recommended.

The other benefit of holding your assets in the same entity is that any losses you have will carry forward.

Let’s say you bought a property for $500,000 that will have a taxable loss of $12,000 each year – holding the property for six years means $72,000 worth of taxable losses.

Let’s say over that period the property increased in value by 5% each year. By the end of year six, the property would be worth $670,000. Let’s say you now sold that property.

Because you’d owned it for more than five years, your $170,000 worth of capital gains would not be subject to the bright-line test.

To quickly explain the bright-line test – the previous National government introduced a law that if you buy a property and sell it within two years then any capital gain you made is taxed as income. This was recently extended to five years. The time-limit, in this case five years, is the bright-line.

Because, in this case, you had sold after the bright-line you wouldn’t have incurred tax on your capital gains. However, even with no other properties left in the entity, you could carry the $72,000 worth of losses forward.

Say that a few years later you decide to buy and flip a property. It might take six months and generate $50,000 in profit. Typically that $50,000 would be counted as income because you’ve sold within the five-year bright-line test.

But because there were losses held within the company, you wouldn’t have to pay tax on those gains. And, after all of that, you would still have $22,000 worth of losses within the entity to offset future tax bills.

Summary

It’s impossible to give personalised financial advice in a blog. What this does show is that now is the perfect time to catch up with your lawyer or accountant. It’s worth taking the time to ensure you have the optimal structure in place for your portfolio and strategy.

At Opes, we offer a complimentary property investment portfolio review to investors who want to combat these Ring-Fencing changes. And we are proud to work with HendersonReeves with our Auckland clients to ensure that they have the