Attack on tax losses signalled

The Government looks likely to escalate its tax attack on investment property by clamping down on the way losses can be offset against other income.

There is already a wide expectation the May Budget will axe depreciation on buildings, one of the tax reform options raised by the Tax Working Group (TWG) in January, along with cutting income tax and raising GST.

However, the government will be under pressure to make further changes to the way investment property is taxed because axing depreciation alone will not raise as much money as the TWG report suggested.

In its January report, the TWG said removing the depreciation allowance would raise "up to $1.3 billion" a year. But, on Thursday, Finance Minister Bill English said additional work done by Treasury indicated the amount likely to be raised by such a move would be "considerably less than the TWG suggested".

That leaves less money to fund planned income tax cuts.

"The trade-offs are a bit tighter," English said.

As it looks for ways to plug the gap, the use of loss attributing qualifying companies (LAQCs) to reduce investors' tax bills is likely to come under the spotlight. Figures obtained from the IRD show that LAQCs play a huge role in reducing the tax take from investment properties.

According to IRD, the number of LAQCs filing returns more than doubled between 2003 and 2008, from 63,400 to 129,900, and the total tax losses relating to residential property investments owned by LAQCs increased nearly 800% over the same period, rising from $105m to $812m.

Those losses would then have been able to be offset against the taxpayers' other income to reduce the amount of PAYE or other income tax.

According to a background paper Treasury/IRD provided to the TWG, the estimated total taxable profits on residential property investments in 2008 was about $1.5b and taxable losses were about $2b. As with the depreciation figures in the same paper, those numbers were also a bit fuzzy.

IRD says it "endeavoured, where feasible to limit the data to residential rental property", but admitted income from commercial property held by individuals would be included in the figures.

"For other entities, we have endeavoured to isolate the residential component based on their description of the nature of their business," it said.

Although the numbers may seem flaky, they give an idea of tax losses being claimed on property. And they are net losses (a loss occurs when rental income is less than deductible expenses such as mortgage interest, depreciation and maintenance; a profit when rental income exceeds deductible expenses).

This means the quantum of residential investment property-related expenses being claimed by investors, whether making a profit or a loss, will be many times the net figure of $3.5b in total profits and losses. It could be tens of billions of dollars in deductible expenses every year. Which makes the depreciation component, whatever the actual figure is, seem like small potatoes.

It would take only relatively small adjustments to the package of costs able to be claimed as tax-deductible expenses and offset against other income, to yield a substantial increase in tax revenue, which could help to pay for reductions in income tax. As the government scratches around for ways to fund income tax cuts, the size of the total deductions being claimed by residential property investors may make them a target that's too big to pass up.

- © Fairfax NZ News