If you are purchasing a residential property for investment with the purpose of generating income either now or in the future, there will be issues of tax deductibility or tax payments to consider. The impact of these issues will depend on the way your ownership is first set-up.
The ownership structures and their implications are outlined below.
We strongly recommend that you consult your lawyer and accountant on the tax implications of your particular circumstances.
Ownership Structures
Options:
Sole Trader
Company
Partnership
Qualifying Company
Family Trust
Trading Trust
All these structures have their own advantages and disadvantages.
Personal circumstances will determine the most appropriate structure for you, however maximisation of tax advantage is often the deciding factor.
Eg, Mr Smith earns $70,000 and Mrs Smith earns $20,000.
How could they maximise their advantage if their rental property makes a $10,000 loss?
In New Zealand, the tax rate at the date of publication of this booklet is 39c over $60,000, 33c below that level. It will therefore be to the Smiths' advantage to claim all losses against Mr Smith's income so that tax is saved at 39c, not 33c. i.e., if all the loss is claimed against Mr Smith's income, the refund is $3,900. If the loss is split, the total is only $2,925.
The challenge is then to create a structure that is both tax effective, and easy to manage. The Commissioner will not allow a structure to be altered simply to suit the current tax circumstances of the taxpayers. It is therefore important to look at an effective long-term structure if, for example, losses are expected in early years and profits in later years, as mortgages are repaid and depreciation deductions are reduced.
Loss Attributing Qualifying Companies
There is a special type of company called a Loss Attributing Qualifying Company (LAQC) which is often an ideal structure to purchase an investment property. This company structure can provide flexibility in the ownership structure.
This tax regime is designed to make the taxing of small family companies more like partnerships. It is often used when a restructuring of affairs is necessary to obtain the best tax advantage.
Main advantages of a Loss Attributing Qualifying Company
Losses can be offset against the shareholders' other income
Dividends paid from capital gains are exempt from tax when received by the shareholders
Main disadvanatges of a Loss Attributing Qualifying Company
Shareholders must elect to become personally liable for any tax liability of the company
Loss attributing qualifying companies - what are they and how useful are they for property investors?
(by M Withers of Wither Tsang & Co Ltd, Chartered Accountants)
A Loss Attributing Qualifying Company is simply a standard limited liability company, which takes on a tax election, to give it Loss Attributing and Qualifying Company status with the Inland Revenue Department.
This regime is only available to companies with fewer than five shareholders. It was introduced to try to make the taxing of small family companies similar to that of partnerships. It has provided an excellent flexible structure for property investors.
In many negatively-geared property investment situations, a tax loss is a result of the acquisition of the property.
The Loss Attributing Qualifying Company is particularly useful given that the loss can be attributed back to the shareholders in the company.
Further planning can be done by considering the shareholding in the company, i.e. there may be an advantage in the highest income earner holding a greater share-holding in the Loss Attributing Qualifying Company to maximise the benefits of any tax losses.
Other advantages of the Qualifying Company regime are that any capital profits made by the company on sale of property can be distributed to shareholders tax-free, by paying an exempt dividend from the capital gain.
This was not possible prior to the Loss Attributing Qualifying Company regime, and again creates a more useful structure for property investors.
The flexibility of being able to change the ownership of the company provides the property investor with opportunities in the future, to restructure the ownership of the assets held by the company without necessarily having to incur recovery of depreciation on sale of the actual property itself.
These advantages should not be underestimated, as the effect of recovery of depreciation can be quite significant and can well become a deterrent to ultimately transferring property, for example to Family Trusts.
The only significant draw back of electing for your company to become a Loss Attributing Qualifying Company is that you accept personal liability for any income tax liability that the company may have.
In summary, Loss Attributing Qualifying Companies have become a widely used and flexible tool for property investors to ensure that their affairs are maintained in a flexible manner, and to ensure that planning is done to maximise interest deductibility against the rental income.
Depreciation
From 1 April 1993, the Inland Revenue Department introduced a new depreciation regime that has increased the rate of depreciation for property investors. The base rate for property is now 4% diminishing value, or 3% straight line.
The new regime also gives investors the opportunity to depreciate the chattels and building fitout within the building at higher rates.
It is essential that investors take steps to value these chattels at the time the property is purchased. Your depreciation claim will be increased significantly by providing a full and fair chattel and fitout valuation. It is one of the most important elements of maximising your tax relief. Contact Withers Tsang & Co Limited for details of a suitable chattel valuer to value your chattels and fitout.
Depreciation is not claimed on the land. To determine the split, Withers Tsang & Co Limited need a valuation. A Quotable Value New Zealand Valuation (previously known as a Government Valuation) or registered valuation is acceptable.
Depreciation Recovered
Each year, the value of the buildings, chattels and fitout items is written down by the amount of depreciation claimed. This is its book value. If the building or chattels is sold for more than its book value, the difference between the lesser of the sale price or the cost price and the book value is added back to taxable income in the year of sale.
Example:
1997 home cost $ 240,000
Depreciation claimed for three years $ 18,816
Book value 1999 $ 221,184
House sold for $ 250,000
Depreciation recovered $240,000 - $221,184 = $ 18,816
Capital gain $250,000 - $240,000 = $ 10,000
Tax Payable $18,816 x .33 = $ 6,209
Depreciation can be likened to an interest free loan. The IRD loans you money in the form of a tax refund on the understanding that the property is falling in value. If you sell the property at a capital profit you have proven that the property didn't depreciate and accordingly you must repay the tax refund that came as a result of claiming depreciation.
Chattel & Fitout Recovery
Despite the land and buildings being sold at a profit it may be possible to reduce the recovery of depreciation by either selling the chattel and fitout items at their book values or having them valued again on sale to prove that they have depreciated. To sell your chattels at book value they should be specified on your sale and purchase agreement.
Capital and Revenue Expenditure
Improvements to the property are capital expenditure and are not deductible.
The cost is only tax deductible as a repair if it does not increase the value of the property or if you replace an existing capital item with a similar capital item.
Example:
Tom buys a residential property and gets a bargain. The property has a rotten deck, so Tom gets the property for a $5,000 discount.
Unfortunately, nobody would rent Tom's property because of the rotten deck so Tom paid $3,000 to have it fixed.
Tom claims the expense because he feels it was incurred to earn the rent and therefore is deductible.
The Inland Revenue Department audit Tom.
Will Tom be allowed his deduction?
No. The Inland Revenue Department finds that the work on the deck increased the value of the property to more than what Tom paid for the property and disallow his claim, even though Tom could not earn rent without doing the work. The price Tom originally paid reflected the rotten deck. However if the deck had rotted over the period of Tom's ownership of the property, the repair would have been deductible.
Legal Costs
Only legal costs associated with raising finance are deductible.
Conveyancing costs are not. Ask your solicitor to apportion the bill.
Non-deductible legal costs are added to the value of the property.
Inspection
The Inland Revenue Department has motor vehicle reimbursement rates that can be used to claim any costs of inspections.
Alternative 1:
Annual work related km Rate
1 to 3,000 km 62c per km
3,001 km and over 19c for each km over 3,001
Alternative 2:
A flat rate of 28c per km regardless of total km travelled per year.
Use of these rates:
These rates can be used to reimburse employees and self-employed persons (including shareholder employees of a company) where actual costs are not kept. The rates are designed to cover all the direct costs of running a vehicle.
It should be noted that the use of these rates in respect of self employed persons or shareholder employees is limited to only 5,000 km per year. If you wish to claim more than this, the claim must be based on the business percentage of total actual costs excluding depreciation. You must be able to prove when, where and why you travelled to establish your claim.
Effect of the Taxpayers Compliance Act
From 1 October 1996, the Taxpayer Compliance Penalties and Dispute Resolution Act became effective.
The Act is designed to move towards a system of self-assessment of income tax by taxpayers and their tax agents. It imposes penalties where a taxpayer is in breach of a tax obligation. It also introduces the charging of interest on short paid terminal tax. This means that if the Department audits a taxpayer and finds there to be a short payment of income tax due to the claiming of non-deductible expenditure, the Department is able to assess use-of-money interest on the overdue tax at a very high rate of interest.
Property investors should watch the areas of interest deductibility, capital versus revenue expenditure and correct depreciation calculations. Taxpayers often take the attitude that any expenditure on a property is a repair and not capital, but fail to take into consideration issues like the timing or level of the expenditure.
The Taxpayer Compliance Act also introduces criminal and civil penalties for offences committed under the Act. The most common penalties will be the civil penalties where they are levied on short fall tax situations under the five following categories.
1. Not taking reasonable care - 20%
2. Unacceptable interpretation - 20%
3. Gross carelessness - 40%
4. Abusive tax position - 100%
5. Evasion or a similar act - 150%
These penalties will be charged in addition to the imposition of interest. The first two penalties are particularly relevant and the IRD has been very aggressive with the imposition of these penalties.
Not taking reasonable care is in relation to the record keeping and calculation of the tax liability. Making an unacceptable interpretation would be a penalty imposed in a situation where the tax agent and the client knew the law, for example with regards to capital and revenue expenditure, but claimed the expense regardless and were not able to provide a valid argument to support the position taken.
The effect of this act has been to penalise the taxpayer if the initial calculation of a tax liability is not accurate.
The attitude of Withers Tsang & Co Limited is that, if expenditure is in a grey area and we are not comfortable making a claim for the expenditure, this expenditure will be brought to the client's notice. Discussions will then be entered into with the client to decide whether or not a claim should be pursued. This is designed to protect the position taken by the tax agent as we feel that involving the client in the decision to make the claim initially is the correct way to deal with marginal calls. Another alternative is to leave the claim out of the original return and apply for a notice of agreed adjustment later. This forces the IRD to look at the specific issue and rule accordingly.
