Landlords bristle over tax claims

Landlords are fuming over claims they get tax breaks that other businesses don't. Catherine Harris asks whether property really deserves to be reined in.

It's not fair. That's what some people have been saying about property against other forms of investment when it comes to tax.

But landlords claim they have been unfairly singled out. In the wake of the Tax Working Group's proposals for changing the tax base, they bristle at the notion they are reaping tax breaks while other asset classes are not.

"A lot of investors honestly feel that they have been unfairly demonised of late and a lot of other problems with the tax system have been overlooked," said one correspondent to the Dominion Post.

"Not all property investors are rich, most are mums and dads that only own one to two properties and are trying to pay down the debt as fast as they can and make a bob in the long-term for their retirement."

This is the problem the Government has. How to appear fair to the 90 per cent of property investors who own only one house, and the many who have a rental, while stomping on speculators and broadening the tax base.

While the family home is likely to be protected, landlords feel under-represented. "Property investing in New Zealand has a very small lobby group with bugger-all funds and hardly any access to media to defend themselves," said Martin Frohlke of Taupo.

He is annoyed people have the impression that landlords can claim tax breaks that other investors cannot. "There is no difference," says Mr Frohlke, a business development manager for a skydiving firm.

"If you buy shares, property or businesses for the purpose of deriving income, you do not pay the zero-rated capital tax in New Zealand. If you lose money on doing so in shares, property or business you are entitled to offset this loss."

Indeed the only difference, says Waikato Property Investors Association president Nancy Caiger, is that investors in assets like shares or bonds do not tend to borrow the money from a bank.

"If you borrow money to buy shares it is also tax deductible so we're no different. We don't ask for any special treatment."

"There are no special tax rules for property," confirms Craig Elliffe, a professor of taxation law and property at Auckland University, "but there are a combination of factors which make it tax advantageous."

Like any other business, landlords can claim depreciation, maintenance, insurance, rates and interest as expenses. But added to that is the writedown on buildings property investors can gain.

"All else being equal if there was no inflation, no house price rises, no economic growth, what would happen is the building would deteriorate over time and would need to be replaced," says Neil Russ, a partner with tax advisory Buddle Findlay.

"But what's happening is land values are going up over time, building values are rising with that and so historically, the instances of buildings showing a loss that would equate to the depreciation are low."

The reason why maintained but ageing buildings fail to lose value, he says, is that over time they become more expensive to replace. Depreciation has to be paid back upon sale, but essentially "it's an interest-free loan," says Mr Russ.

"And this is what the Tax Working Group is pointing out, why should the system allow that when there is no real likelihood of economic loss?"

However, he acknowledges landlords still need to be able to claim for maintenance and for "real losses," if a sustained property slump occurred. "I would be very surprised if they touched repairs and maintenance because it's too fundamental."

Making the tax system fairer is being viewed with more urgency as the Government watches high-income earners and companies disappear across the Tasman. "We have a highly mobile tax base upon which New Zealand has an excessive reliance," Professor Elliffe says.

The latest concern is that Australia will drop its corporate tax rate to 25 per cent, leaving New Zealand on 30 per cent.

If the Government was to align company, personal and trustee tax rates at 30 per cent, it would need to find an estimated $1.6 billion somewhere else. That's where property looks attractive. At an estimated value of $213 billion, it's worth five times the sharemarket.

CRITICS of property maintain that it's an unhealthy bias. "I disagree that there are not any tax advantages to investing in rental property," wrote Phil Harris, of Christchurch investment advisory firm Rutherford Rede, recently.

"If it was not, how do you explain the disproportionately high percentage of property investors in New Zealand relative to other asset class investment and also relative to other OECD countries."

But one landlord, an experienced finance manager and sharemarket investor, says the real reason is Kiwis understand property and have been burned by finance companies and sharemarkets. "That is the main reason for property investment, before tax enters the equation ... To blame tax advantages for property's historical attraction is misleading."

He also points out that those who argue for a level playing field fail to mention that other asset classes have advantages too. Shares in certain countries get imputation credits and the PIE investment vehicles have lowered the tax take from many shareholders.

Of course, property investors are not averse to making a buck either, which is why experts believe Australia's property boom outstripped New Zealand's – despite that country's capital gains tax.

However, most landlords are not in it for short-term gain, according to Nancy Caiger. She says if speculators are the target, clarifying the present tax criteria would be just as effective. "I would say a capital gains tax is already part of the system. It's just not enforced properly."

Where she believes the current system falls down is that Inland Revenue's test for tax is based on the intention to turn a short-term profit.

And the difficulty proving intention is why speculators get the upper hand, Mr Harris says.

"All property investors know this."

Critics also argue that property is a passive use of investment money. Despite its size, the property market pays no tax; in fact, it refunds between $150m and $200m a year.

However, property investors argue investing in a rental is a productive business, generating jobs for handymen, builders and accountants, and just as risky as any other investment.

"Property needs to be managed, the business needs to raise finance, typically a number of consultants or professionals are employed to advise on the running of the business," says one landlord.

"It may be easy to make money when the property market is rising. It is quite another matter in a falling market or when interest rates are rising."

All the same, the Government still has a problem: how to find a "revenue-neutral" way of funding its tax changes.

Introducing a land tax would have low compliance costs if councils collected them in addition to rates. But it could also create a politically unpalatable drop in property prices. The Government could do away with depreciation, saving a hefty $1.3 billion if commercial buildings are included.

But, Nancy Caiger adds, landlords already only get a pittance.

"When you have to replace a roof ... and then you get back $1000 and you have to wait like 20 years to get back your money, your expenditure is much higher than what you can claim back in depreciation."

Other options include "ring fencing" tax losses on rentals, so landlords can't offset them against personal income, a potential saving of $165m to $195m.

A capital gains tax on the sale of a property could save $3.8b. There would be no onus on proving intent, it could exempt the family home, and could give a rebate for those who hold the property long term.

This happens in Australia, where investors get a 50 per cent rebate on capital gains tax if they do not sell the property for a year. But this and another option, the risk-free rate of return, could have longer-term effects on the housing market.

Rents could go up as a result of landlords passing on their tax increases or quitting the sector, creating a scarcity of rental houses.

But in Taupo, a capital gains tax matters little to Mr Frohlke, "as I am not selling my properties, I am interested in the income from them".

"Compared to shares, it is much better, safer, under my control and not dictated by the performance of that company but how well I serve my customers, ie tenants."

While BNZ chief economist Tony Alexander believes tax changes need to occur, he thinks bold moves are unlikely.

"It's not a government that is looking to make radical alterations to the economy."

But Mr Russ thinks the Tax Working Group has done a good job and "the cynic" in him hopes the Government will take note.

"We've had the McLeod report, we've had the committee of experts, we had Don Brash's work last year ... so we've had a lot of worthy work and this is a great opportunity right now to grasp some of the key distortions in the system and fix them."Catherine Harris is a landlord.

The pros and cons of tax reform:

Land tax. Taxes the unimproved land value only. One of the easiest to administer, perhaps with rates. However, Westpac estimates a 0.5 per cent land tax slicing 4 per cent off house prices and 11 per cent off land prices. Prof Elliffe says it is unlikely such wealth destruction would be allowed. But BNZ economist Tony Alexander disagrees that house prices will fall much. After all, he says, if the most massive economic crisis in decades can't keep house prices down, a well flagged tax change won't.

Capital gains tax. Paid on the profit made on the sale of a property. In Britain, Nancy Caiger says, the rate of inflation is subtracted first. Westpac estimates a 10 per cent capital gains tax would slice 15.7 per cent off house prices. Prof Elliffe believes it would also be "quite wrong" if it did not apply to all investments. It is unclear whether it would apply to farming.

Scrapping depreciation: Would affect the fewest number of people, but could lower the quality of the rental stock. Tony Alexander: "People won't want to sell their properties straight away and if they can't get a tax benefit from claiming depreciation, they'll look to offset the cash flow loss probably by cutting other expenses."

Imposing ringfencing: Would mean landlords could only offset losses against future rental income, not their personal tax bill. Some argue LAQCs – vehicles for loss-making ventures – have a valid business use for limited liability partnerships and individuals as well as landlords. Massey University's real estate expert Bob Hargreaves: "If you want to do something that is politically acceptable and is not going to affect the average Kiwi who's a home owner but perhaps doesn't have a rental property, I would suspect the outcome would be somewhere down that track."

Risk-Free Rate of Return: Taxes equity – the difference between property value and bank debt – at a proposed 6 per cent multiplied by your tax rate. Rental income would not be taxed and expenses would not be deductible. Could save $850 million but Westpac says rent increases and a huge house price fall of between 26 to 34 per cent are likely. Other problems are complex compliance costs and deterring people from paying off debt.

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