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Cracks In Loss Ring-Fencing Proposals

Mark Withers exposes a key problem with the residential property loss ring-fencing proposal.

By: Mark Withers

1 October 2018

Since the passing of the foreign buyer ban, the media has been vocal in its criticism of a government initiative that many see as doing more harm than good when it comes to making housing more affordable for first home buyers. As we await the real impact of this ban we also await the detail of the bill that the Government is supposedly intending to pass into law on April 1, 2019 to ring-fence tax losses on residential rental properties.

It’s been many months since the official’s issues paper closed for submissions and very little has been heard on the fate of the bill since.

I speculate that this is one of the reasons: The officials’ issues paper proposed that residential rental losses be ring-fenced on a “portfolio basis” rather than on a property-by-property basis.

This means that if you have a portfolio of properties, some making profits, some making losses, you would only be ringfenced if your overall result was a loss.

This position seems to be a pragmatic one based around the complexity of determining a property-by-property profit or loss position when debts will be cross collateralised. And the difficulties with a track and trace exercise on the specific use of borrowed money relative to any given property are complex and have a high compliance cost.

But, stop to consider the fundamental problem with this legislation if portfoliobased ring-fencing is the adopted method.

Consider for a moment that interest rates are only just over 4% on average at present and rental yields on residential property are similar. It’s probably fair to assume that an investor with a portfolio of properties will have been in the game long enough to have accumulated some equity in their rental portfolio. If this is the case it’s also a fair bet that in the absence of depreciation allowances these investors holding portfolios will in fact be profitable and paying tax on their cash rental surpluses.

‘New investors simply can’t compete with the wealthier ones and are effectively priced out of the game, the rich getting richer thanks to more bad law’

Uneven Playing Field

Now, picture what happens when this investor is pitted against a first-time investor at the auction of a property.

Let’s assume the property being purchased must be fully debt-funded by both bidders. It’s likely then that the net yield will result in a tax loss being generated after interest costs. But the portfolio investor adds this loss-making property to his existing profitable portfolio and has the benefit of offsetting this loss against other rent. And in so doing, gains a tax deduction and is totally unaffected by the ring-fencing proposals as long as the loss doesn’t tip the entire portfolio from profit to loss.

The other investor though only has his salary to offset the loss against and is accordingly ring-fenced by the proposed rules and denied a tax saving.

So, this law then sets up a situation where we have two classes of investor. The wealthy ones with profits who can add more property and utilise tax losses to offset existing rental incomes and save tax without impact from the ring-fencing rules. And the newer investors who don’t yet have investment portfolios that produce profits and are as such impacted by the ring-fencing of losses.

The wealthy investors should therefore be celebrating the buying advantage handed to them by a government that doesn’t think through the consequences of its tax law changes.

This may result in a situation where those new investors simply can’t compete with the wealthier ones and are effectively priced out of the game, the rich getting richer thanks to more bad law.

We can only wait and hope that the submissions being contemplated by those drafting this legislation have given some pause to really think through the implications of this type of change.

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