Ring-fencing of Residential Rental Losses

It’s official, property investors will no longer be able to deduct their expenses relating to their loss-making residential investment properties from their other income like salaries and wages or business profits. The changes are already in force with the Act including the changes receiving royal assent on the 26th of June.  The rules will apply from the start of the 2019/2020 income year, which for most of us means from 1 April 2019 (five months ago!).

The typical scenario we all recognise is to use the existing equity in your home to borrow up to 100% of the purchase price of a residential rental property. The ensuing interest charges, together with rates, insurance, and repairs create losses, which then reduce your business income, or the PAYE salary resulting in lower tax or cash refunds. As the mortgage on the rental property begins to reduce, so does the interest charge, where eventually the rental property begins to make a profit. Typically, the process is repeated with a second rental property acquired using the equity in the first. Losses continue to be generated thereby reducing other taxable income. And the process continues until the person has a sizeable portfolio of rental properties. On the basis that these properties are owned for at least five years, the absence of any capital gains tax then allows the investor to sell down those properties over time to fund retirement needs.

New section EL 4 of the Income Tax Act 2007 provides that you will still be able to claim rental property losses against future rental income from residential properties, though any excess of expenses over income will essentially be ‘ring-fenced’ and they will have to be carried forward to future years. This means that whilst you don’t lose the benefit of those losses for tax purposes, you cannot apply those losses against your other taxable income. This may have a significant effect on cash flow for some property investors, particularly those who need the reduced tax or refunds for maintenance, or to reduce debt. Accordingly, you need to see these new rules largely as a timing deferral for when you can use the losses. The only difficulty is of course that you need cash now for maintenance, debt reduction, and income tax.

You should also be aware that under the existing definition of residential land, your Gold Coast apartments, and any other residential land you own overseas will also be included in this regime. 

The new rules use the same definition of residential land that already exists for the bright-line test. There are a number of exclusions, with the main ones being:

  • your (or your trust’s) main home.
  • Land held on revenue account, that will be taxable due to being acquired for a business relating to land. In some instances, the taxpayer will need to make a notification to Inland Revenue for the exclusion to apply.
  • A company that is not a ‘close company’.
  • Land that is subject to the mixed-use asset rules (commonly holiday homes) as these
    already have their own form of ring-fencing.
  • Property that is provided to employees or workers in connection with their employment or service.

The default position is that these rules apply on ‘portfolio’ basis. If rental property 1 makes a loss, you will be able to offset that loss with the profit from rental property 2. You do not have to wait until rental property 1 makes a profit before you can use its loss.  However, for completeness, if your portfolio of rental properties creates an overall loss for the year, that loss that cannot be used to reduce your other taxable income. This portfolio type approach is at least one positive aspect of the new rules. If a taxpayer elects (by taking a position in their tax return) the rules can also apply on a property-by-property basis.

A number of property investors use trusts and companies to own their residential rental properties.  The new rules extend to these entities as well.  Slightly more sophisticated investors might choose to borrow money from the bank in their own name to buy shares in their residential rental company. The interest charged by the bank to them personally would relate to them purchasing shares, rather than purchasing a residential rental property. In that case, because the ring-fencing rules only apply to interest charges in respect of residential rental properties, the interest should be fully tax-deductible.

As you would expect, Inland Revenue has thought of this, and they have concluded that if your company or trust is considered to be “land rich” (over 50% of the assets are residential rental properties), your interest expenditure will be treated as a residential property rental expenditure. This will be calculated with reference to the trust or company’s capital that is being used to buy the residential rental.

As always with new legislation, we expect that a few issues will pop up once we continue to work through the detail. If you have any questions or scenarios that might impact you please get in touch. 

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