Tax changes advice heralds doom

BY GREG NINNESS

Proposed changes to the tax treatment of property investments will be the final nail in the coffin of the debt-funded, low-yielding residential property investments popular during the boom.

To look at how a raft of tax changes proposed by the government-appointed Tax Working Group could affect investors, we used the example of an investment apartment bought by an Auckland couple at the height of the property boom in 2007.

To protect the couple's privacy we have changed their names to Smith, but all other details of the financial arrangements for the purchase of the apartment are real.

The Smiths purchased the apartment on the advice of their financial planner, who worked for Sarnia Financial Services (a company now in liquidation) which drew up the financial arrangements, promising the couple that it would "create real riches through effective property management".

The apartment was part of a good quality, new mid-rise development in an excellent location on the fringe of Auckland's CBD and the Smiths paid $371,000.

It was rented out for $400 a week giving nominal rental income of $20,800 a year, equivalent to a gross yield of 5.6% on the purchase price.

The couple were not well off, but were in reasonable financial shape. Although they had young children, both had jobs (Mrs Smith worked part-time), and between them they had a gross household income of about $98,000 a year. Although they didn't have much in the way of savings, the mortgage on their suburban home was modest, leaving them with several hundred thousand dollars in equity.

Under the plan prepared by Sarnia, the entire $371,000 required to purchase the apartment was borrowed as an interest-only loan from Westpac, secured by mortgages over the apartment and their family home.

This was a common way of buying investment properties during the boom and there would be thousands of other investors throughout the country who made similar arrangements.

The interest payments on the loan to Westpac were $29,287 a year and when other expenses such as property management fees were added, the Smiths' total outgoings were estimated by Sarnia at $32,500 a year.

That meant their outgoings on the apartment were $11,700 a year more than it was providing in rental income.

On the face of it, that appeared to be a hopeless investment. It provided a large dollop of negative income, with no prospect of that situation changing in the foreseeable future.

So why did the couple go ahead?

Sarnia's projections were based on the premise that property prices would keep rising at the same pace as they had done during the boom.

They estimated the apartment would be worth $504,000 within four years, providing the Smiths with a handy capital gain of $133,000.

In the meantime, what made it stack up from a cash-flow perspective were the tax benefits that property investment provided.

The interest payments were a tax-deductible expense, and to these Sarnia's financial planners added substantial depreciation expenses, starting at $25,500 in the first year and decreasing to $21,600 in year three.

That provided total deductions of about $55,000 a year, which the Smiths were able to offset not just against the $20,800 in rental income from the apartment but also against the income from their jobs, reducing their PAYE by about $8000 a year.

When that was taken into account, the negative cash flow from the investment (the amount by which the Smiths had to dip into their own pockets to fund it) was cut to about $2500 a year.

That was less than $50 a week, which seemed a worthwhile amount to pay for the $133,000 capital gain they hoped to make within four years.

However, the investment relied heavily on tax benefits to stack up. It would not have been financially possible for the Smiths to buy the apartment without those tax breaks.

So how would the main changes proposed by the Tax Working Group affect those arrangements?

One proposal is to axe depreciation as a tax-deductible expense on investment property.

That would reduce the amount of expenses the Smiths would be able to claim by $25,500 to $21,600 a year, which would be likely to increase their tax bill by about $5000 a year.

So the amount they would probably have to find each week to sustain the investment could increase from less than $50 to about $150.

That may still be manageable, but it would be starting to hurt.

Another proposal is that none of the expenses arising from a property investment would be tax deductible, and investors would be taxed at a flat rate on the amount of equity they had in the property.

In its report, the Tax Working Group used 4% as the tax rate applying in the example it gave of how such a tax would work.

If an investor owned a property with a market value of $300,000 and owed $200,000 on the mortgage, taxable annual income would be set at 4% of their $100,000 equity in the property.

In that case their taxable income would be $4000 and they would not be able to deduct expenses such as interest costs, depreciation or management expenses from that amount. If they were taxed at the marginal rate of 38%, they would have to pay tax of $1520, regardless of the actual return the property provided.

In the Smiths' case, because the property was entirely debt-funded and they had no equity in it, they would not pay tax.

But they would not be able to continue claiming the $55,000 in taxable deductions for interest and other expenses either.

That would mean they would have to meet the entire shortfall between the property's rental income and its outgoings themselves.

Their cash shortfall would increase from about $2500 a year to $11,500, or about $221 a week, putting significant strain on their household budget and leaving them vulnerable to financial shocks such as any reduction in income or unexpected expenses.

Matt Baker, the director of taxation services at accounting firm Staples Rodway, said that would be enough to send many property investors to the wall.

He believed that if the government introduced the proposed changes, they should apply only to investments made after the rule change, and not to existing investment properties.

"There are people going to the wall now under the current regime, which is supposedly so favourable. If you start hitting them with an extra tax bill and they've got no cash flow, it's going to be devastating," he said.

Baker was also surprised the Tax Working Group did not recommend the ring-fencing of investment properties' tax deductions, something it was widely expected to do.

That would mean investors could only offset expenses such as mortgage interest payments against the income the property generated, and would not be able to use them to reduce tax on other income such as a salary.

Even though the working group's report did not examine that option, Baker said he believed the government was still likely to consider it.

- © Fairfax NZ News