WT..... on Tax Working Group Report
At long last the Tax Working Group has released their recommendations on tax changes and it is now up to government to decide what they will act on.
Here are our thoughts and comments on the proposed changes, particularly as they will affect property investors.
Firstly the good news:
The recommendations include reducing the high personal tax rate to 30% and aligning this with a reduced trust and company tax rate that will be set to remain competitive with Australia.
Given most property investors are higher income earners, often salaried employees who have no ability to structure to avoid high tax rates, this change is welcomed.
That is about where the good news starts and ends.
Property investors will clearly be targeted to balance the fiscal fall in the personal tax take.
The specific proposals to achieve this may include:
Increase GST from 12.5% to as much as 15-17.5%.
Whilst an increase in GST affects everyone, not just property investors, residential investors are hit particularly hard by an increase in GST as residential renting is GST exempt and as such a residential investor is a net payer of GST as they are unable to claim back the GST paid. Typically, investors will pay more GST on rates, insurance, maintenance, and improvements to properties.
Introduction of a land tax of half a percent
Introducing land tax is "low hanging fruit" for the government. It is easy to calculate and easy to predict the tax take. Land tax is also not new in New Zealand. We have had it before and it would be easy enough to reintroduce.
It would probably tax the CV of land at 0.5% annually, subject to exemptions for private houses, and land worth less than $50,000 per hectare. This exemption would exempt most farm land, Maori land, and DOC land. This now looks to be a relative certainty. The only positive aspect of land tax based on the way it worked previously in New Zealand was that it was a tax deductible cost at that time. Westpac economists predict a 0.5% land tax could push down property values by 4-5% and a 1% land tax could push down values by 15-17.5%.
Removal of depreciation on buildings where evidence suggests they are appreciating
Another kick in the guts for investors.
Depreciation is the second biggest tax deductible expense for the average investor, second only to mortgage interest. Removing this deduction would have a serious and immediate cash cost to all property investors, commercial and residential. Whilst depreciation is only a timing advantage for investors, given it is subject to recovery on sale, the depreciation recovery is typically dealt with out of proceeds from a property sale.
Removing depreciation claims on buildings will deny those who purchased, based on calculations supported by this deduction, the level playing field they had expected. Spare a thought for the beleaguered owners of leaky investment buildings. I wonder how they feel about the suggestion that their buildings don't depreciate. Another easy one to introduce, seems a sure bet.
Taxing a risk free rate of return (RFRR) on residential property investors
Whilst the recommendations don't seem to push this proposal as strongly as land tax and removal of depreciation on buildings, the report states that a majority of the committee are in favour of the government considering it.
Given that John Key has already signaled his desire to target residential investors, its inclusion in the recommendations means it is by no means ruled out.
This is a very scary prospect for investors and because it is completely new territory, an explanation of how it would work is necessary. Deemed rate of return to tax residential property is not a feature of any other country's tax law.
As an example:
An investor owns a $400,000 rental property with a $300,000 mortgage. His equity is therefore $100,000.
Currently, he prepares an income statement and claims a refund for his losses, given that costs exceed rent.
Under risk free rate of return, the government sets a deemed rate of return at say 6%.
Our property owner has to declare $6,000 of income and pay tax on this despite actually making losses.
He is not required to file a rental statement and can claim no expenses.
If introduced, this would have a devastating effect on current property investors as it would turn their refunds into tax payments at a time when they are still expected to fund their losses. Their properties would also fall significantly in value as investors would move to sell loss making properties.
We can only hope that the government will view this option as one step too far.
From our perspective, we don't believe this will be introduced for the following reasons:
- It would create a tax disadvantage to repay debt and build equity
- Given the extent of cross collaterialisation of debt against properties, both homes and rentals, it is practically difficult to determine the equity level in any given property, particularly where cross collaterialisation often crosses between entities like trusts and companies
- The regime has never been tried before and would be totally new. Very complex to design, set up, and enforce
- Westpac economists predict that RFRR would cause a 26-34% decline in the value of residential property. If that happens, we are really in trouble!
- The "equity" that investors have that government hopes to tax may simply vanish
Capital gains tax
Whilst the tax reform committee talk very positively about the benefits of CGT, the reality is that John Key has already all but ruled it out.
In some ways this is a pity because at least CGT would only be payable once a gain has been realised. When compared to the horrors of risk free rate of return, CGT starts to look unexpectedly good.
What isn't being recommended?
Thankfully, we seem to have dodged the bullet of ring fencing of tax losses.
The prospect of being denied the ability to offset rental losses against other income was very scary for many.
Thankfully, this proposal doesn't get a mention in the recommendations.
Stamp duty and death duty are also not in the proposal.
So, final thoughts and some advice:
Whilst the fall in personal tax rates is welcome, the reality for most geared property investors is that they will be paying far more in property related taxes now than they will save in income tax.
Whilst rents may rise somewhat, all of the negative property tax changes will have the effect of bringing more of the current rental stock to the market to a greater or lesser degree, depending on what the government adopts.
This increase in supply, as some investors look to exit, will certainly reduce house prices particularly at the low end of the market.
It is likely that the government will confirm which proposals it will bring into law in this year's budget. The changes will probably be timed to take effect from the beginning of the 2012 tax year.
Given that deemed rate of return is on the list of possible changes, we'd suggest investors take advantage of what is left of this tax year and the 2011 tax year to attend to any repairs and maintenance issues they may have on their properties, as being able to claim these costs could vanish if RFRR is adopted.
We will keep you informed of all the changes and our advice in coping with them as we learn more about what will get adopted.
In the mean time, if you disagree with the report, contact your local National MP and tell them what you think of the changes.
The political implications for the government are high stakes and they wouldn't be politicians if they weren't trying to determine how much political capital these changes will burn.
|
