Property Investing Tips & Advice...

Rental Property – Tax Tips

Buying and owning rental property can give you some tax breaks –
The IRD take the view that a rental property is a business –
But it is very important to structure things correctly BEFORE
You buy your rental property to maximise tax advantages.

STRUCTURE What is the best structure to maximise tax benefits on a rental property?

This depends on the circumstances of the purchaser. If the property is going to be mortgaged, it is probably going to be best to own the rental property in your own name, or in a partnership, or as a Loss Attributing Qualifying Company. All of these structures allow you to pass any rental losses through to the purchasers personally for a tax refund. If a company (non LAQC) or a Trust owns the property, any losses incurred can be carried forward, but it may be years before the rental property makes a profit to offset these losses. This gives an immediate cash disadvantage.

Loss Attributing Qualifying Company – is a closely held company (no more than 5 shareholders), which is incorporated as a company, and thus has a separate legal identity, but there are special tax advantages to the shareholders. Losses in a LAQC can be passed through to shareholders, not just carried forward in the company. In an LAQC, it does not matter if there is an overdrawn shareholders advance account – this can attract interest or FBT in a normal company. And shares in a company, including an LAQC can be held in any proportion you like – it does not have to be 50% each. This means, for example, if a husband and wife own a rental property in an LAQC, the husband has a good income and the wife does no paid work, the husband can own more of the shares, and hence can claim more of the losses and thus get a larger tax refund. This cannot be done in the normal partnership. So a property can be owned by an LAQC, giving the shareholders the benefit of limited liability, but any losses can be transferred to the shareholders, thus maximising tax benefits. A good deal all round!!

Trusts – If the property is not mortgaged, however, or only a small mortgage is required, it is a good idea for a Trust to own the property. A Trust can be a powerful estate planning tool, as family members, including infant children, can become beneficiaries of the trust. If a rental property is making rental profits, these profits belong to the Trust, and can either be distributed to beneficiaries, or retained in the Trust, at the Trust tax rate of 33%. As the top individual tax rate is now 39%, this can provide some tax relief for higher income earners. It should also be remembered that Trusts are often used for asset protection as well as for estate planning. If you are in business, and are concerned that your personal assets may be at risk to your creditors, assets owned by a Trust are protected because – well they are owned by a Trust, not by you yourself.
We come across many cases, however, where a rental property is mortgage free, and the owners are living in a mortgaged property. This is crazy. You cannot claim any mortgage interest on the house you live in, but you claim it on a rental. From a tax point of view, it is best to have as much of your mortgage as possible attached to the rental property. But it is important that you organise this BEFORE you buy the rental property. The IRD will not allow you to restructure your affairs to gain tax advantages after you have bought the property.

WHAT CAN I CLAIM? Sad but true, you have to pay tax on any rental profits made. But the fact is, most rental properties make losses, at least in the first few years. Against your rental income you can offset any rental expenses incurred – rates, insurances, repairs, mortgage interest, advertising, depreciation, travel costs. It is important to note that the costs of acquiring the rental property are not deductible for tax purposes. The main expense here is legal fees. Legal fees on the purchase of rental property are not tax deductible. Legal fees for acquiring a mortgage, however, are fully tax deductible. Also, in the sale of your property, neither legal or real estate fees would normally be tax deductible.

REPAIRS v CAPITAL IMPROVEMENTS This is an area where you have to get it right, otherwise some of your rental property expenses will not be fully deductible in the year they were incurred. If you have just bought a rental property, any work you do to get the property ready for renting is classed by IRD as capital improvement, and is not fully deductible. You have to add the costs to the original purchase price, and depreciate the total (purchase price + improvement cost) over the life of the property. So, if you are buying a house in poor repair, make sure you get a good price because any repair costs will not be immediately deductible for tax purposes.
Once tenanted, however, most repair costs are fully tax deductible in the year incurred. You still have to be a bit careful there though. IRD will force you to capitalise and depreciate any repairs that increase the value of the property. Say you have a leaking roof. Repair it – no problem. Replace it with a roof of similar quality and standard – this will almost certainly be classed as a repair – you can’t have a house without a roof. Go for burgundy Coloursteel, however, and this will increase the value of the property, and so the cost cannot be fully deducted as a repair cost in the year it was done – even though the house needed a new roof.Sounds crazy? Not really. IRD are not going to allow you to spend a fortune, fully tax deductible, on upgrading your house for you to make a massive profit when you come to sell it, because that profit is not taxable. But if you are sensible about the repairs you do, you can keep your property in good order, and get some good tax breaks. Just forget about the gold taps in the bathroom.

DEPRECIATION We all hope that our rental property will increase in value while we own it. Mostly, this is true. However IRD still allows us to claim depreciation on the property while we own it. Normally, this is calculated at 4% of the cost of the building only (not the land) and is allowed as a deduction for tax purposes.There are pitfalls here, however. When you come to sell the rental property, if you make a profit on the sale, (and most people do), although there is no tax on the capital gain that you have made on the property, IRD are going to expect you to pay tax on any depreciation claimed on the property while you owned it. You can elect NOT to claim depreciation on the property while you own it, which means that you will not have to pay tax on depreciation recovered on the sale. However, you have to ELECT to do this – ie IRD have to be informed of this decision up front. My advice – don’t worry about it. Depreciation gives you an added tax benefit in the early years of owning a property. If you have sold the property (and most people sell rental property within 5-6 years), you may have to pay some tax on depreciation recovered, but you will have had the proceeds of the sale, so you can afford it. If you make a loss on the sale of the property, there is no depreciation recovered. You have lost enough.

BETWEEN TENANTS? So your tenants have moved on (as they do) and it takes a few weeks to relet the place. What about the costs involved here? So long as the property is at all times available to rent, any costs incurred – advertising, minor repairs, mortgage interest, rates, etc – are fully deductible. If, however, your tenants have moved out, and you have decided to tidy the place up to sell it – well no, any costs incurred here will not be tax deductible. Here, it all depends on intent. If you have decided to sell, you are not in the business of rental property any more, and so tax deductions on your costs ended the day your last tenants moved out. If you intend to rent, however, you can’t – well, by and large, any costs are fully tax deductible.

GOING OVERSEAS? Many people rent out their homes while they spend some time overseas. Lots of people think that this is a good way of getting some tax breaks on their property while overseas. Well, yes it is, but be careful…remember what I said about being in the business of rental? IRD take the view that. The day your tenants move in, you are in the business of renting property, and you can claim all expenses against your rental income. But, the day you come home and decide you want to move back into your old home – well, you just stopped being in the business of rental property, and IRD now takes the view that you just sold the property back to yourself. No actual money has changed hands, but IRD are now looking for their cut of depreciation recovered. And, they will deem that a sale has taken place at the market value of the property on the day you move back in. So, you can find yourself with a tax bill on a sale that never happened. Ouch!!One way to avoid this is, if you are renting out your property while going overseas, and it is your intention to return and live in the property, do not claim depreciation during your absence. You have to declare all rental income and other costs, of course. But remember, you must ELECT not to claim depreciation in your absence. This means you must inform IRD in advance of your intentions. Otherwise, IRD will deem that depreciation has been claimed, and will charge you tax on depreciation recovered anyway. And, believe me, you don’t want that!!