Property sector does not receive special tax privi

February 22, 2010

Property sector does not receive special tax privileges

Geordie Hooft, Tax partner at Grant Thornton New Zealand, rebutts claims that the property sector enjoys priviledged status

A lot of criticism has been directed towards the property investment sector because of perceived “loopholes” in the taxation of income from rental properties. Do such loopholes actually exist? Let us compare investing in property, investing in shares and investing directly in a business.

Income
All investment income is taxable. Rental properties earn rent from tenants. Shares earn dividends. Businesses profit by selling goods and/or services.

Cash expenses
Very broadly, if you have to spend money to earn money, the expense is deductible. Holding shares may incur management fees charged by an advisor. Businesses incur materials, wages and overhead costs. Property owners suffer rates, insurance and repair costs. The rules for claiming expenses are the same regardless of the type of investment.

Financing costs
Interest charged on money borrowed to buy an income producing asset is generally deductible. Property investors pay mortgage interest. Business owners incur interest on business loans. Even share investors are entitled to a deduction for interest on funds borrowed to buy shares.

Depreciation
Businesses are entitled to a deduction for depreciation on assets they use, based on Inland Revenue rates, to recognise their diminishing value over time.

Property investors can claim depreciation on the assets they use, including buildings. That is contentious, mainly because buildings tend to increase in value over time. However, that is a result of the market at work: people are willing to pay higher prices even though buildings physically deteriorate. A depreciation claim is allowed for a notional expense that may never materialise. What critics overlook is when a building sells for more than its depreciated value, the previous depreciation deductions reverse, and become taxable. At worst, depreciation on buildings is no more than an interest free loan. Still, if the evidence is that buildings do not decline in value, then there is an argument to support a depreciation rate of 0%.

Shares are not depreciable property, so no deduction is available.

Capital gains
If a business is sold for more than the book value of the net tangible assets the capital gain is generally not taxed. The same applies to shares. Capital gains are generally not taxed, provided the investor did not acquire the shares with the intention of selling them for a profit and is not in the business of buying and selling shares.

The rules applying to land investments are harsher. Unlike shares, a property investor can be taxable on their capital gain simply through association with another person who is a property dealer, developer or builder.

Tax rates
The tax rates that apply to various entities (eg companies 30%, trusts 33%, individuals up to 38%) apply regardless of the activity of the entity.

Loss Attributing Qualifying Companies
LAQCs are often maligned because they have a special tax status that allows losses to be passed through to shareholders. Many property investors erroneously believe that they need an LAQC to offset tax losses arising from rentals. In fact, losses can be offset against other income where property is held directly by a person. LAQCs are useful for property investment only in a couple of specific situations. However, LAQCs are appropriate for situations other than property investment; simply abolishing them would be disruptive and inappropriate.

Conclusion
New Zealanders have a love affair with property. Factors other than tax drive investment decisions. It may be its tangible nature, the perceived stability of prices or the comparatively easy credit. It is unfair to point the finger solely at the tax system.

The current tax rules generally apply equally to all investment categories. Depreciation on buildings may be inappropriate. In other cases, property is subject to rules already more onerous than that faced by alternatives. The Government’s 20 May budget will specify what changes will be made to the taxation of property. Whether that will be denying depreciation claims or ring-fencing losses, it will lead to further distortions in the way that property is taxed compared to other investments.

ENDS

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