The Labour Government’s new law that ring-fences residential rental losses is an appalling example of badly crafted tax law that seeks a social engineering outcome rather than making a meaningful contribution to government revenue.

The new law is designed to make residential property investment less attractive by preventing residential investors from being able to offset legitimate tax losses against anything other than rental profits from an existing portfolio or income triggered under the land taxing provisions like the bright-line rules.

And here is the first realisation with the rules: they are shockingly unfair; not only do they single out residential property investment as the only business to have losses ring-fenced, they create two distinct classes of investor. An investor with a profitable portfolio can add a loss-making property to the portfolio and net the loss off against their existing profit and achieve the same tax saving they always have. But, a first time investor buying the exact same property and incurring the exact same loss will be denied the same tax saving because they only have employment income to offset the loss against rather than rental profits.

So we have a new “haves” and “have nots” situation where there are two classes of investor, those in business class (wealthy investors with profits unaffected by the new law) then those in economy, aspiring investors, who are not wealthy but will bear the brunt of the new law. Will they still invest? They certainly aren’t at the moment, as the Government gets its wish and sees the property market moving into decline as confidence drops at an alarming rate.

Will this open the door to first home buyers to fill the void? It seems unlikely when the ring-fencing rules will have no impact at all on wealthy investors with profitable portfolios. They will simply be pleased to see competition from new investors eliminated.

Defining Residential

Next let’s consider how this masterfully crafted piece of legislation defines a residential property. For this exercise I would like you to imagine you own a building in a mixed-use zone that has a shop on the ground floor and a flat above it, both of the same size. You are tasked with finding out whether the loss ring-fencing rule impacts you. The ring-fencing bill borrows the definition of residential land from the bright-line test. Residential land includes:

1. Land that has a dwelling on it;
2. Land for which the owner has an arrangement to erect a dwelling; and
3. Bare land that may be used for erecting a dwelling under the rules in the district plan.

So having determined that our mixed use commercial property meets the definition of residential land, because of the flat, we have to see if we can get out under an exemption.

The first exemption is a main home exemption, this is useful only if you have a rented dwelling in your own home.

The second exclusion is for mixed use assets, i.e. your rented bach.

The third exemption is for farmland, but don’t get excited you life-stylers, it has to be a real farm.

And fourthly, we have an exemption for “business premises”.

But the business premises exemption only applies where the land is used predominantly as business premises. The commercial shop can’t be considered to be the predominant use of the property as it’s used equally for commercial and residential use. Due to the poor drafting it is now up to IRD to release guidelines on how they will interpret the predominant use test in situations like this. If the rent from the commercial is higher than the rent from the flat but the square metres is the same, could this be considered predominant use? On the upside, the use as business premises does not require the usage to be by the landowner.

I also foresee problems where dwellings are let on a short term basis. Does the business activity associated with the short term letting mean that these dwellings are business premises? Nobody knows at present, and again, we must hope for sensible guidelines from IRD to make sense of badly drafted law. Given the significant rise in short term letting, these rules could potentially incentivise owners of residential land to change the use to short term and argue that the buildings are business premises. I wonder what that would do to availability of rental housing for permanent occupation?

Mark and his team specialise in advising on property-related transactions, valuation and restructure services, and tax planning. Withers Tsang & Co Phone 09 376 8860, www.wt.co.nz