In his 2010 budget, Bill English summed up the property investment aspects of his budget as an effort to introduce a fairer tax system to ensure that the tax treatment for investment properties is consistent with other types of investment.

This article sets out a summary of the changes that will impact residential property investments.

Changes to depreciation
With effect from the 2011-2012 income tax year, residential (and commercial) landlords will no longer be allowed to claim depreciation allowance for buildings with an estimated useful life of 50 years or more.  Under existing rules, landlords, property investors generally claimed either a 2% or 3% deduction on the purchase value of the building. 

With immediate effect, the 20% loading on some plant and equipment (P&E) has been removed on all new P&E bought since 20 May 2010.

Changes in how Loss Attributing Qualifying Companies (LAQCs) are treated
LAQCs have long been a popular structure for many New Zealander residential property investors.  The main attraction has been that losses could be deducted to reduce LAQC shareholders’ taxable.  

These are going to be changed.  But, currently, there isn’t enough information available on how the new LAQC regime is going to work.  Bill English commented that, after after a brief consultation period, new legislation will be introduced so that, with effect from 1 April 2011, LAQCS will be taxed as limited partnerships.  Submissions will close on July 5 2010.

Tax losses will continue to be attributed to shareholders, but taxable profits will also be attributed to those shareholders and not retained within the company.  Therefore profits may be taxed at the shareholders’ top personal income tax rate of 33%, rather than at the lower company tax rate of 28%.

Changes to GST
With effect from 1 October 2010, GST will rise from 12.5% to 15.0%.  This will have a real impact on residential investment property owners as the cost of insurance, rates, property management fees, and professional services will increase.

As many residential investment property owners are not normally registered for GST, they will not be able to claim back the GST component of these expenses.  So unless rent is increased to offset these additional costs, residential investment property owners will see less cash in the bank.    

The changes to depreciation on buildings may have major cash flow implications.  Added to that, the changes to the LAQC regime are wide reaching.

If you are an investment property owner, you should contact us to review your property investment portfolio.  You’ll need to consider the implications these changes will have for you.  You should also seek advice before buying more investment properties or changing existing ownership structures.

The IRD has recently indicated that it intends to increase its audit activities on investment properties and will investigate these transactions more regularly.

- Accountancy fees for the preparation of property accounts,

- Bank charges both for loan applications and administration fees provided they relate to the property

- Small items of routine repair say for less than $5oo

Certain expenses, to be eligible for tax deductions, require some explanation.

Home office expenses: This is the claim for a tax deduction if you are running your property business out of your home. The costs that can be claimed include proportionate amounts of mortgage interest payments, insurance, utilities and so on.

The New Zealand IRD department is unlikely to allow home office expenses in the case of properties that are passively managed. In other words, your property investment needs to be actively managed and to qualify as a business. To qualify, the home office must not include a bed.  Apparently, the IRD department have been known to check. Consult a chartered accountant if you have any doubts.

Insurance: Any legitimate expenses in connection with insuring your home and its contents are fully deductible for tax purposes. Many property investors take out home and contents insurance on their income properties because many items are not covered by the replacement cover of a home insurance policy. Banks often stipulate mortgage insurance cover in the case of a high loan to value for income properties. These premiums are also fully deductible.

Legal fees: There are two elements to the fees – mainly fees for property conveyancing and fees for mortgage registration. The IRD will allow the deduction for mortgage registration but considers the conveyancing costs to be a capital cost and therefore not deductible. It is advisable to ask your lawyers to bill separately for the two elements. If no split is readily available, the normal practice is to claim a deduction of 50 percent of the total bill.

Interest costs: This is by far the highest cost that a property investor is likely to incur and therefore requires careful consideration. The cardinal principle is that the borrowing on which interest deductions are being claimed should have been used for the sole purpose of acquiring the income property.  If the borrowing for the acquisition of the income property is not properly structured, there can be a considerable loss of tax efficiency. The situation is quite complex and you should consult your chartered accountant before structuring the finances.

Investing in New Zealand property can be a rewarding experience but before you begin to do so, retain the services of a top-notch accountant to handle your tax.

You may be looking for high rental yields (often at the expense of capital appreciation) or for high capital appreciation (with a sacrifice in the yield). Your accountant will help you to plan the correct mix of investments in a well balanced portfolio. Your portfolio should probably be tilted towards rental yields since you will see returns on your investment almost immediately. Investing for capital growth takes a lot of patience since you can never be sure how long you will need to hold the property. Your accountant will also almost certainly advise you to settle for the bird in hand.

Get your chartered accountant to explain yields

If you are investing for rental yields, the underlying assumption is that the value that you are willing to pay for a property depends on how much rent you will receive.

With the guidance of your accountant, establish a minimum yield below which you will not consider buying a property. You may decide that a minimum yield should cover all of your borrowing costs, assuming that you are borrowing 100 percent of the value of the property.

If mortgage rates are running at seven percent per annum, rental yield should be seven percent plus. In other words, let’s assume that you are considering a property for $400,000. You would only consider buying it if you can rent it for at least $28,000 per year. If you spend some time scouting out rentals for similar properties, you can arrive at a pretty accurate estimate of your yield.

Ask your chartered accountant about internal rate of return (IRR)

IRR is a more complex calculation but there are a number of spreadsheet software packages that will perform the calculation for you. Factors such as capital appreciation, rental, and expenses (like taxes and insurance and tax benefits) are included in the calculation.

The internal rate of return will be the return that you achieve on the capital that you have actually invested. For example if your return is $28,000 per annum on an investment of $360,000, your IRR is 7.78%.

IRR versus yield

Whilst IRR can produce a more accurate investment appraisal, subjective factors such as capital growth can render it unreliable. You are probably better off staying with the simple and easy to understand yield method. Concentrate on maximising rental returns and treat any capital growth as a bonus.

Rental properties have been an excellent investment for many Kiwis. You should consider them as an integral part of your investment portfolio. Get started on your investment plans today by getting in touch with your accountant.

The taxpayer generally has 2 options:

• Wait until the tax year ends on 31 March, prepare their rental property tax return and then wait up to 3 months for the IRD to process their income tax refund.  If the tax refund is significant, extra scrutiny from the IRD may further delay processing.
• Apply for a special tax code.  With a special tax code an employer deducts PAYE from the tax payer at a lower rate. Therefore they effectively receive a portion of their tax refund every pay period instead of receiving one refund after their tax return has been filed.

This may not suit everybody as some tax payers prefer the lump sum tax refund.  However for those tax payers looking to increase cash flow, option 2 may be better.

This is how a special tax code works…At Business Advisory Accounting & Tax Services, we prepare a brief forecast for your rental property to estimate the loss for the forthcoming tax year and submit it to IRD for approval.  After approval, your employer deducts a smaller amount of PAYE from your regular salary, giving you the benefit of the tax loss now.

Both options produce the same tax refund but option 2 allows the tax payer to use their tax refund a lot earlier.  This “extra” cash may come in handy to repay loans, which would further increase cash flow as a result of paying less interest.