Ah yes, property. The much vaunted class of investment that many kiwis put their life savings into. Over the past decade, residential rental investments have been the investments of choice for many kiwis (who can afford it). Part of this boils down to the astounding growth of NZ properties and the lack of capital gains tax on residential properties.
However in the past 3 years there have been huge changes in the residential property market here in Aotearoa. A lot of the tax strategies used 10 or even 5 years ago are no longer relevant today. I would say that recent tax law changes have made residential rentals a poor option (tax-wise) for kiwis looking to grow their investment.
But, there are still a lot of kiwis who view residential rentals as a sound investment. If this is you, then this article is for you. Please note that this article is aimed at first time investment property buyers. If you are a property dealer, developer or builder or are closely associated with entities/individuals who are – these tips may not apply to you.
Residential Rental Tax Tip #1: New build or No deal.
Make sure that the residential property you are buying is classified as a ‘New Build’ Property. This will have a host of tax implications. A ‘new build’ property is classified as a self-contained residence that is issued a Code Compliance Certificate (CCC) confirming that the residence was added to the land on or after 27 March 2020.
27 March 2020.
That’s the magic date. Any residence that receives its CCC before that date cannot apply for new build exemptions. Here’s a quick summary of what new build exemptions will get you vs non-new build
|New Build||Non-New Build|
|Bright line test – 5 years (if acquired after 27 March 2020)||Bright line test – 10 years (if acquired after 27 March 2020)|
|Interest expense deductibility – 100%||Interest expense deductibility – 0% if loan was drawn on or after 27 March 2021 (gradual phasing out if loan was drawn prior to 27 March 2021)|
Bright line test
The bright line test is the test that determines whether or not you declare profit on the sales of your property as taxable income. Main homes that you live in are usually exempt from this. Despite its name, the Bright line test is the closest that Aoetearoa has to a capital gains tax. Any property sold within the Bright line period will have its profit on sales taxed.
In the case of new builds, this is 5 years, as opposed to 10 years for non-new builds. For a breakdown of the bright line test check out the IRD website.
Interest Expense Deductibility
This is the most significant ruling affecting residential rentals in the past 3 years. For the past decade or so, rental owners have been able to claim 100% of interest expense on mortgages taken out for rentals. From 27 March 2021, this is no longer the case. Unless the rental property is a new build.
Interest expense can easily form up to 50% of the operating costs of a rental. Not being able to claim that as a tax deduction can put a strain on your finances.
New builds please
As you can see, new builds offer better tax terms that non-new builds. If you are in a position where you have to sell the rental within 10 years, you won’t be hit by the bright line rule, as long as you sell after year 5. Being able to claim all the interest expense, instead of none of the interest expense is also very significant.
Residential rental tax tip #2: Think about your ownership structure
A lot of first time investors will buy their first residential property in their own, individual name. It may be worth to spend some time investigating what other entities you can set up to hold your residential rental investments in.
Individual ownership/Look-through companies (LTCs)/Partnerships
An LTC functions similarly to a partnership in that all losses and profits from the company/partnership flows through to its shareholders/partners. From an income perspective, its no different than earning rental income in your personal name.
Please note that if you make a loss on your residential rental property, those losses will be ring-fenced from your main income. Losses made on rentals can only be offset against other rental income. This applies regardless if you are holding the property individually or via LTC or Partnerships. You cannot use losses from rentals to offset your main income.
If you sell your rental within the bright line test period, profits will be in your name. If you make a gain of more than $200,000 on the sale, this will definitely bump your total income up to the highest tax bracket (39% as of when this article was written).
Limited Liability Company
A company offers its shareholders’ personal assets a degree of protection from its creditors. This means that if a company fails to meet their debt obligations, their creditors cannot go after the personal assets of their shareholders. There are some limitations to this rule, as directors can still be held personally liable. Generally speaking, holding your rentals in a separate entity from your own, personal home is a good idea, since it doesn’t expose your own home to unnecessary liability.
28% is the company tax rate. Any loss made by the company cannot offset your personal income. Losses are carried forwards to offset future income made by the company. Basically, you are operating your rental like you are running a business. Tax of 28% will apply to all profits made by the company at the end of the year. You also have the option of declaring shareholder salaries to shareholders who have done work for the company. You can also declare dividends to shareholders.
Family Trusts are popular entities to hold investment properties in. Trusts offer a certain level of protection for your investment assets, especially if you run a business full time as it protects your assets from your creditors. However, the tax rate for Trusts is a flat rate of 33%, which is much higher than 28% for companies. You can distribute income from the Trusts to the beneficiaries to be taxed in their personal name. Losses cannot be distributed to beneficiaries to offset their main income.
From a tax point of view, Trusts aren’t the best entity to hold your rental properties in. However, you should consider holding your personal home in a Trust. This protects it in the event of any personal and/or business liability. Trusts are typically more expensive to set up compared to companies, LTCs and partnerships, hence why their attractiveness as investment vehicles have diminished over the years.
Residential rental tax tip#3: Beware of the ‘associated persons’ rule
The tax tips shared apply to regular, average kiwi investors. Different rules apply if you are a:
- Property Dealer (frequently buys and sells own property)
- Property Developer
Generally speaking, any profits made on sales and income from residential properties held by any of these individuals/entities are taxable. Bright line rules and new build exemptions don’t apply to them. Note that if you are an associated with a business that deals in any of the above industries, the same rules apply to you.
If you are a shareholder in a property development company (for example) you are deemed an ‘associated person’ and may have to pay tax on all your residential rental transactions. Even if you have sold a property after its bright line period. If you are an associated person or think that you might be one, it’s a good idea to talk to a tax professional to consider what you best options are.
Take your time before investing!
Buying a residential rental property is a big commitment and will put you even further in debt. So think about your options carefully! Its a good idea to consult with property lawyers and tax professionals before making your first purchase. Keep an open mind to other types of investments as well! Rental properties may not even be the best type of investment for your financial goals!