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Consequences Of Ring-Fencing

Mark Withers gives his take on the recent ring-fencing of losses Bill.

By: Mark Withers

31 December 2017

Finally, after months have passed since the issues paper was released for submissions, the Government has released the Bill that is set to ring-fence residential property losses.

The law is predicted to raise a further $190 million annually from the property sector. Alarmingly, the Government admits in its risk analysis that it has no real idea what the law will do to the housing market and expects to be unable to identify the direct impacts due to the other initiatives being deployed to dampen the housing market at this time.

So, What Is Loss Ring-Fencing?

Ring-fencing is designed to prevent a taxpayer from offsetting a legitimate tax loss from a residential investment portfolio against other forms of taxable income. The loss from the rental property must be “ring-fenced” and carried forward to be offset only against future taxable income from the rental portfolio. That income could be in the form of future rental profits or taxable income from a land transaction or bright-line disposal.

Why Are They Doing This?

Because they see investors gaining a tax saving from a rental loss without the requirement to declare capital gains as income. They see this as being a contributing factor to the housing crises with first home buyers at a disadvantage when pitted against investors.

So What Are Key Features?

Firstly, the bill is very closely aligned with the original issues paper that was released that formed the basis of the submission our firm made on these rules.

Very little has changed, but it does seem the government has been somewhat challenged by the question of whether to ring-fence on a portfolio basis or a property by property basis.

Here’s the rub: the Bill’s default position is to ring-fence on a portfolio basis but there is an opt out elective option if you wish to have your loss ringfenced on a property by property basis.

Ring-fencing on a portfolio basis means that if overall a property portfolio is profitable, there is no ring-fencing just because some of the properties in it may make losses. This is a huge issue with the effectiveness of this legislation because it means an investor with a profitable portfolio can add a loss making property to it and still gain a tax advantage provided the portfolio overall is still profitable. But an investor buying the same property who does not have other rental income to offset the loss against is ring-fenced and can’t gain the same tax saving.

With interest rates at 4%, more or less level with residential yields you don’t need much equity now to be profitable. Our client survey indicated 65% of residential property investors we act for are in fact profitable and paying tax.

This legislation therefore creates two types of residential investor, those that are profitable and can grow their portfolios continuing to gain tax advantages by offsetting losses against existing rents and those that aren’t who must suffer the effect of the ring-fencing.

On first look, it’s very hard to imagine why an investor would elect voluntarily to have their losses ring-fenced on a property by property basis but seemingly, the addition of this option may represent the Government’s attempt to somehow address the unfairness of a portfolio based approach. Has it worked? No.

What Will The Consequences Be?

The introduction of ring-fencing on top of the five year bright-line and the foreign buyer ban and the changes to the Residential Tenancies Act will further dampen Kiwis’ enthusiasm for residential property investment.

I believe those investors who are willing to buy more property will set their price expectations relative to a yield that will deliver a taxable profit because there is no tax upside now to booking losses. Given residential rental property yields are currently typically below the cost of funds I believe the value of residential investment properties will fall, to deliver the buyers that remain with higher yields.

Will rents also rise, yes probably, if the net result is that residential landlords withdraw from the sector leading to a shortage of rental property, rents will rise.

I suspect there will be a combination of both a fall in value of residential investment property and an increase in rents to arrive at an equilibrium where investors will buy to drive taxable profits.

Mark and his team specialise in advising on property-related transactions, valuation and restructure services, and tax planning. Withers Tsang & Co Phone 09 376 8860, www.wt.co.nz

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