Making loss and being taxed is a risk, when not knowing the taxation rules. Know how to spend on home improvements, maintenance or repairs and claim rent-deductible expenses.
Taxation Rules for Landlords
Being taxed when making loss
Making loss and being taxed, yes—possible
Taxation levels the playing ground, right? But always right is wrong! I came across a number of “funny” taxation rules. One of them is being taxed on “intention” in NZ. That rule divides business people such as property developers and traders from people who just run a landlord business or those who passively invest in residential properties to cumulate wealth for a comfortable retirement.
The tricky part is—what happens when the tax department disputes your “intention” or the initial intention has changed? Consider the compliance cost to prove your position or being accused of tax avoidance, unpaid tax, interest on late tax payment and penalties. A grey area to be aware of.
Taxation rules for property investors
In contrast to other industries the housing market has been and always will be in the spotlight because of its gravity for politicians, voters and just people who are looking for a place to live.
The property market is driven by emotions and suffers from high costs, a dated housing stock and low rental yields. Landlords have always been good for taking the blame on increasing rents and investors for the housing shortage. Low rental yields and local payments on behalf of tenants e.g. for water and infrastructure result in cloudy market rents. It is difficult to compare rents with other nations who charge water and council rates to households directly.
Another example for driving down the yields was to remove the depreciation on residential properties made in April 2010 and new definitions of rent-deductible expenses. Let me illustrate.
Example for paying $237 tax despite of $2880 loss
Assume you let a three bedroom house for 390 Dollars per week by paying on a 200k mortgage 6% interests, $5000 for levies, fees, maintenance – you earn by 52 weeks occupation 3280 Dollars annual rent. That is in theory because the average occupancy is only 49 weeks. That would reduce your annual profit to 2110 Dollars or monthly cash-flow to 175 Dollars.
Now, it is not unusual to happen that the tenant, who run into rent arrears, abandoned the tenancy. A damaged property, 4 weeks vacancy for doing repairs and finding new tenants are the consequences. In this case 4 weeks vacancy reduced the positive cash-flow to 1720 Dollars. Still positive you might think while the rent arrears would be covered by the bond.
With common sense the landlord decided to do long planned home improvements because the accidental vacancy offered a time window for getting the builder in. Good thinking to take this opportunity, right? Well, here is the catch—home improvements are not rent deductible!
At the end of the financial year spending 3700 Dollars for home improvements resulted in negative cash-flow ($1980 loss). But still the landlord had to pay tax on 1720 Dollars on rental income. When holding the rental property in a trust (tax rate 33%) the additional income tax would be 567 Dollars.
The only protection you have is knowing the taxation rules. A similar situation can occur if you don’t know the changed depreciation rules for buildings and chattels.
Improvements are not rent-deductible
As landlord you can only survive if you plan improvements and work out the numbers before starting any renovations. Improvements have to be capitalized being added to the property value. But the depreciation for buildings has been changed to NIL – in other words the landlord does not get reimbursed for “wear and tear”. Only replacements/repairs are rent deductible!
Repairs which significantly improve the value of a property, for instance you replace a broken window with a new double glazed window cannot be claimed as a rent-deductible expense. For more download the IR 264 guide.
Watch out for “Negative Gearing”
Negative Gearing (negative cash-flow) as the result of increasing interest rates is a risk for an investor with low amounts of equity. Off-setting loss against income from different sources is a risky strategy as “Ring-Fencing” (taxation to avoid that) is not off the government’s agenda.
Currently NZ has already ring-fenced everyone who is not holding investment properties in their own name or an LTC. For setting up an LTC (Look Through Company) that replaced the LAQC (Loss Attributing Qualifying Company) in April 2011 is recommended taking professional advice.
The new capital gain tax rules (Bright-line Test for Residential Land) Act 2015) was introduced Oct 2015. Actually, IRD’s ability to tax capital gain on investment properties has always been there. But the change makes it easier to draw a line between an investor and a trader/developer or speculator.
Frequent changes to taxation for property investors can make you succeed or fail. Know the rules, there is no “free meal” and don’t cross the line. Good luck
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Klauster Blogs lead to a real person who worked as computer network architect for many years in different countries until retiring from IT and mastering a life as property investor and landlord.
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