Last month’s budget effects landlords of residential property. This article published by Crockers Market Research Department gives a good overview of how the changes impact on investment property owners.

Depreciation on buildings

From the start of the 2012 income year, you will not be able to claim depreciation on buildings with an estimated useful life of 50 years or more. As it happens, residential rental properties are considered to have an estimated useful life of exactly 50 years.

If you have a standard 31 March year end, you will not be able to claim any depreciation on your rental property from 1 April 2011. However, you can still apply to the Commissioner for a special depreciation rate (as you can at present) if you believe your building has a useful life of less than 50 years. Note that such exceptions are only granted in very limited circumstances.

It’s possible to apply to the Commissioner for a special depreciation rate where the actual economic life of a particular item is expected to be significantly different to the estimated economic life used to prescribe the depreciation rate. To determine the special depreciation rate, the factors taken into consideration are likely wear and tear, exhaustion and obsolescence. This can be determined using for example, a valuer’s report. Accordingly, if the building is only expected to last 10 years due to it being a leaky building and you have a report to show this, it is possible to apply to Inland Revenue for a depreciation rate that depreciates the building over its 10 year expected economic life.

The 20% depreciation loading currently allowed for new assets will be removed for all purchases after Budget Day. Landlords must ensure that the correct depreciation rate is applied for assets purchased after 20 May 2010.

These changes clearly have the potential to affect your net rental income (or loss). For example, if you currently generate a tax loss on your rental property, the loss may now be significantly reduced, or you may even end up owing tax. If so, you may need to consider making provisional tax payments in the new tax year, if you’re not already doing this.

Building fit out

The income tax treatment of fit-outs will be reviewed and rules around the splitting of buildings from building components will be clarified. Repairs and maintenance expenditure will remain deductible for income tax purposes, while depreciation deductions will remain for “fit out” items not considered to be part of the taxpayer’s building.

Increase in the rate of GST

When GST increases from 12.5% to 15% on 1 October 2010, the purchase price of most goods and services bought by landlords will naturally increase too. In theory, that will ultimately result in a higher “cost of build” for properties destined to become residential, which could increase the market value of already existing comparable rental properties.

How much will those values increase? Past experience (for example when GST was first introduced) has shown this to be very hard to accurately predict.

Conversely, unregistered landlords (which includes most residential landlords) will experience higher operating costs, resulting in either smaller rental margins or increased rentals.

Qualifying companies and loss attributing qualifying companies

LAQCs are common throughout the residential rental property market. From 1 April 2011 QCs and LAQCs will be treated as flow through entities (similar to limited partnerships). As now, losses may still be offset against a shareholder’s personal income tax (subject to our comments below). However, any taxable profits the company makes will be taxed at the shareholder’s personal income tax rate, rather than at the company tax rate, as now.

The reduction in the top personal tax rate from 38% to 33% also effectively reduces the value of rental losses that can be claimed against other income for landlords who were on the 38% tax rate.

The LAQC regime will also be modified to include a “loss limitation rule”, currently contained in the limited partnership regime. This will allow a shareholder of the LAQC to offset net losses for tax purposes only to the extent of their investment in the qualifying company.

As used here, investment includes any capital investment in the company plus any debt guaranteed by the shareholder. For example, if your investment in the qualifying company is only $50 of share capital and you have also guaranteed $100,000 of the mortgage over the rental property, then a total of $100,050 of tax losses can be offset against your income. Obviously, if you have not guaranteed the qualifying company’s mortgage obligations then loss you can claim could be very small ($50 in the example above).

The problem of the loss limitation rule is completely avoided where a rental property is held personally by the investor. In that situation, an unlimited amount of losses generated by the rental property can be offset to the owner(s).

If you hold a rental property in a LAQC and are considering transferring it to your own name or to a partnership with your spouse, take care with the sale. A sale from a related LAQC to you personally constitutes a sale to an associated person and, for tax purposes, it will be deemed to have taken place at market value.

The sale may also result in depreciation recovery (income) in the LAQC. Depending on the level of depreciation recovery, the company may need to consider paying provisional tax in the year of sale. Inland Revenue could also argue that the reason for the sale was merely for tax purposes and that the arrangement constitutes tax avoidance. You would therefore generally need other commercial reasons for changing the ownership rather than merely to save tax.

There’s yet another “fish hook” in the transfer of depreciable property between associated persons: Even though the present market value of the property may be significantly higher than the qualifying company paid for it, the purchaser’s depreciation claim must be based on the original price the seller paid. For practical purposes, this particular fish hook will not often arise, as the general restriction on depreciation of residential rental properties will usually override it. However, it should be borne in mind in relation to any commercial property presently held within LAQC structures.

Working for Families Benefit

You will no longer be able to use investment losses (including rental losses) to reduce your income in calculating eligibility for the Working for Families benefit. Investment losses will be added back to the taxable income for the purposes of determining such benefits.

Inland Revenue investigations

The Government’s budget for property transaction audits and ensuring compliance has been increased by $119.3 million over the next four years. This signals the Government’s commitment to ensuring that people trading in property are taxed on their trading gains. Although rental property investors are not generally classified as land traders, it is prudent to be aware of the proposed Inland Revenue activities in this area.

Kindly contributed by Staples Rodway Limited, the Auckland representative of a national network of independent chartered accounting firms.

Article courtesy of Crocker Market Rearch June 2010.