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A good reform, but a minor one

Written By: - Date published: 9:00 am, November 4th, 2009 - 37 comments
Categories: tax - Tags:

I watched Terminator 3 last night. It’s the worst in the series but that’s still better than watching another Guyon-National lovefest*. Which is a long way of saying I didn’t see the Bill English ‘debate’ on TVNZ7 last night. But apparently the most interesting part of it was English didn’t rule out changes to taxation on investment properties. Labour’s David Cunliffe and the Green’s Russel Norman supported such moves. So, whoo, consensus.

Of course, no-one’s asked John Key yet and he has a nasty habit of reflexively shutting down debate over anything politically risky by emphatically ruling it out. And a habit of cutting his deputy off at the knees.

Basically, the tax changes would ring-fence housing investment losses from other income, so landlords can’t avoid tax by negatively gearing their investments (the rent doesn’t cover the interest). The Reserve Bank of Australia has identified negative gearing as the prime cause of housing unaffordability because it has allowed the wealthy to push houses prices out of the reach of the rest of us (creating a bubble at the same time).

The Tax Working Group says ring-fencing won’t raise a whole heap of money – $500-$900 million a year. Enough to pay for a small off-setting tax-free bracket ($1300-$2400) but it would probably be better used to support public services and decrease the amount we need to borrow to fund the government deficit.

When Australia introduced ring-fencing (temporarily) it had the expected effect of reducing housing speculation. This should have resulted in depressed house prices, deflating the bubble, and allowing more people to own their own homes but  house prices actually continued rising because construction slowed with less investor demand and rents rose because there were fewer landlords and those there were could no longer afford to negatively gear. If that becomes an issue here, the government can always build more state houses with its increased revenue to keep the supply of rentals up and rents down.

It’s not good enough that the entire rental industry gets away with paying no net tax. Loss ring-fencing and other measures are a good step to redress that unfairness.

I doubt this government will take up the larger proposals from the Tax Working Group for capital gains and land taxes. Let alone pollution taxes that raise money while encouraging polluters to clean up their act. Really, we should reforming the tax system away from burdening work to punishing pollution and removing the distortions that cause over-investment in land instead of productive capital. Unfortunately, I don’t think this government has the courage to make that kind of real change.

*that reminds me, does anyone watch Q+A any more? I for one am not getting up at 9 on a Sunday to watch softball interviews from Holmes and Guyon.

37 comments on “A good reform, but a minor one ”

  1. prism 1

    Interesting post – housing treated as a sure investment solid, relatively risk free has been utilising happily taxation soft-bedding for too long. Investors have options of discounting tax with strategically managed depreciation, and offsetting housing income losses resulting from buying at inflated housing prices paid in expectation of capital gain, against other income. This has fuelled housing inflation and subsequent unaffordability for the ordinary Jo and Joe.

    This is ironic while other parts of our economy have been under tight inflation control, yet housing costs can be half of weekly income. It’s a very twisted economic drive allowed to continue by twisted political aims – good money has been made on books and lectures advising how to utilise this anomaly to make great returns, though probably glossing over examples of tenancy difficulties that can break investor.

    • George.com 1.1

      Interesting comments from Martin Hawes on the radio yesterday abut the difference between investment and speculation. Investment is having an asset return enough income to justify the amount you paid for the purchase. Speculation is playing for a rising market. Hawes looks for cash flow to pay for his investment. Any market rise is a bonus.

      Applied to housing, if the rental pays for the outlay then that is a good investment. Having to rely on tax writes offs to make things viable or buying on the hope of a rising market smack of speculation.

      Rob

  2. RedLogix 2

    It’s not good enough that the entire rental industry gets away with paying no net tax.

    Or the other way of looking at it, is that the Govt has been for many years subdising the industry allowing us to charge very low rents. When these changes are bought into effect prices will increase across the board by 20-40%. That will hit the lowest income people hardest.

    As a landlord I plan on approaching my tenants and starting the conversation along the line,”You remember that tax cut north of $50pw that nice Mr Key promised you?”. And then explain why their rent is going up 30%.

    Oh and if you think the Nats are going to build a whole swag of low cost State Houses to fill the gap….

    Still think this is a good idea Marty, or just indulging in more good old landlord bashing mentality?

    • gitmo 2.1

      “Or the other way of looking at it, is that the Govt has been for many years subdising the industry allowing us to charge very low rents. When these changes are bought into effect prices will increase across the board by 20-40%. That will hit the lowest income people hardest.”

      Why should the taxpayer be subsidising the development of your housing portfolio ?

      • RedLogix 2.1.1

        In recent times rental returns have been as low as 3-4%, which is absurdly low. Tenants have been the main benefactors of this. (Historically they used to average around 10%).

        Around 58% of landlords are ordinary people with 1-3 properties, and they never go much past that. Only a small 5% minority go on to build what you call a ‘portfolio’ of 10 or more units.

        The income of most of these smaller businesses is typically about 60% rental income, about 20% tax rebate and the remaining 20% is put back in by the owner. Yes, many of us actually put cash into the business… very few are actually pulling large amounts of cash out.

        Ring fence the losses, and rents will have to rise. You figure who looses.

        • gitmo 2.1.1.1

          “In recent times rental returns have been as low as 3-4%, which is absurdly low. Tenants have been the main benefactors of this. (Historically they used to average around 10%).”

          So about the same return as money in the bank on which you pay tax on interest, I also suspect you are enjoying the benefits of lower mortgage charges at present ?

          “Around 58% of landlords are ordinary people with 1-3 properties, and they never go much past that. Only a small 5% minority go on to build what you call a ‘portfolio’ of 10 or more units.”

          Around 95% of taxpayers are ordinary people what’s your point ?

          “The income of most of these smaller businesses is typically about 60% rental income, about 20% tax rebate and the remaining 20% is put back in by the owner. Yes, many of us actually put cash into the business very few are actually pulling large amounts of cash out.”

          So why does this mean you should be subsidised by the taxpayer to develop a housing portfolio be it one house or multiple houses ?

          • gitmo 2.1.1.1.1

            Sorry Red I should declare my bias on rental properties.

            I own a few and do so primarily to minimise tax, it’s also a safer bet than investing in the local sharemarket – which is sad.

          • RedLogix 2.1.1.1.2

            Tax losses are a common feature of all new and growing businesses, regardless of what type.

            Your statement:

            So why does this mean you should be subsidised by the taxpayer to develop a housing portfolio be it one house or multiple houses ?

            can be reworded with equal validity to say:

            “So why does this mean you should be subsidised by the taxpayer to develop a business?”

            If you object to businesses being able to claim for expenses like mortgage interest, maintenance, depreciation, legal and accounting expenses… just say so. But you will have to explain why your objection only applies to rental businesses..

    • Sam 2.2

      Oh boo hoo, some people might not be able to afford to invest in housing anymore. Isn’t that what we want?

      If they can’t afford to continue renting out the house (helps if tenants tell them to stick it and find a new place to live) then we have more houses on the market, and as the law of supply and demand tells us, the influx of supply should (theoretically) bring house prices down. The problem is though, bully landlords offloading your extra costs onto the people who can least afford it. I imagine that in order to cope with this there will need to be some movement from the government – additional state houses? Perhaps even taking advantage of an influx of rental properties on the market…?

    • Blue 2.3

      Every time this issue comes up landlords make this same point about rents going up. But you can’t get blood out of a stone, RedLogix. In the midst of a recession landlords will not be able to raise their rents by that much or they will find themselves without tenants.

      The next step is usually to threaten to quit the rental housing industry altogether, thus restricting supply of rentals and driving prices up.

      I think there needs to be a conversation had in this country about how many rental houses we actually need. We’ve been trapped in a vicious cycle for some years where house prices get higher so more people have to rent, thus increasing rental ‘demand’ and the incentive for investors to buy more houses to rent out to supply this ‘need’.

      Last estimate I saw was that 600,000 houses in NZ are in the hands of private investors.

      Do we really need that many? Especially if a price crash means that more people can afford to buy?

      • RedLogix 2.3.1

        There is a perfectly legitimate market for rental property. In many overseas countries its much larger than the 40% it is here. People rent because at their stage of life it makes no sense to buy. Or a toxic combination of low wages and their own poor behaviour with money means they haven’t got a deposit… not even a little one.

        Besides you forget that if we suceed in crashing the property market by flooding it with landlords offloading houses they can no longer afford to keep.. it will of course drag down the rest of the market. The other 60% of people who own their own homes will really love that enormous loss of equity. (Ask your parents.)

        • Blue 2.3.1.1

          Some people won’t be worried about that, RL. Say, those who don’t use houses for anything other than living in, who have paid off their mortgages and don’t have any debts secured against their houses, and who know that buying and selling are done in the same market.

          But this is New Debtland, after all. How many people subscribe to such and old-fashioned way of life?

          • RedLogix 2.3.1.1.1

            who have paid off their mortgages

            Of the 60% who own their own home, only about 1/3rd of them are mortgage free. They tend to be over 50’s or retired people. Ask a young couple with baby on the way, and a brand new mortgage with 80% or more LVR… just how they feel about having 30-40% slashed off the value of their new home.

            If ring fencing happens, I’ll just bang my rents up and ride it out. It won’t hurt me personally… but my tenants will be paying the price.

            I’m no fan of property bubbles; most cautious long-term investors like me are hate them because they distort the market and encourage stupid speculative behaviour. The way to fix these bubbles is to attack the root cause of the problem, which is banking behaviour. I guess my main point is that fiddling with the tax system like this is bound to have a whole bunch of unintended effects.

            • Blue 2.3.1.1.1.1

              Banks do have a role to play in this bubble, I agree. They’re not the only factor – a whole system has developed to push house prices up – it’s not just one factor and it won’t be solved by only dealing with one factor. But something needs to be done, however small.

              The combination of lax tax laws and banks falling over themselves to lend money on property has been toxic.

              When bubbles burst, someone always gets hurt, RL. That’s why I believe the former Labour Government should have done something to stop it inflating in the first place. When it does burst, it’s going to hurt like hell.

            • RedLogix 2.3.1.1.1.2

              In normal time a bank will normally lend at least 80% LVR on property. They won’t lend you that for shares, or an overdraft in a non-residential business.

              In fact if you went to a bank and asked to borrow 80% for some shares, even in their own bank they would turn you down.

              If you have two people, both with say $100k in cash, both bidding on a property, and Eddie’s bank will lend him a standard 80% LVR, and Marty’s bank will go to 90%… it doesn’t sound much… but Eddie can only bid to $500k on the property and Marty can go to $1m. Now of course Marty only has to bid $505k to win the bidding, but that is the power of LVR ratios.

              And that more than anything else is what drives property prices. At the peak of the last bubble us long-term investors had our cheque-books firmly shut for a year or two. Prices were just silly too high. Real investors look for undervalued assets that we can add value to… we never lead the market by paying top dollar for anything.

              Regulate banks LVR ratios and the asset bubble problem goes away. It’s that simple.

          • Quoth the Raven 2.3.1.1.2

            My parents are mortgage free and don’t use their house for anything but living in, but I’m sure they wouldn’t be happy if their property suddenly lost a lot of its value.

    • modern 2.4

      RedLogix’s quotes:

      “When these changes are bought into effect prices will increase across the board by 20-40%.”

      “In recent times rental returns have been as low as 3-4%, which is absurdly low. Tenants have been the main benefactors of this.”

      No no no… you’ve got it totally the wrong way around. Yields have fallen (and are are now low) because house prices have been rising (and are now high).

      The rental price is the exogenous variable here; the house price is determined endogenously by the rental price, the borrowing rate, expectations of the path of future rental prices (or future capital gain, the same thing), and any tax breaks available to rental property or owner-occupied property investors.

      ie, the rental price comes first, and it’s determined on the demand side by wages, population, transport costs, family sizes, and on the supply side by the size of the housing stock. The house price comes second.

      The only way that rental prices have been influenced by the various tax breaks for property is via the influence on the size of the housing stock.

      Two notes: firstly, the influence of tax breaks on new construction is small – most of the benefit of the tax breaks was to reducing the tax bills of ‘investors’ who bought and sold existing properties.

      Secondly, any construction increases due to the tax breaks have now been manifested in a greater housing stock, which isn’t going to go away if the tax breaks are removed.

      The old “remove our concession and rents will rise” claim is a furphy. I don’t doubt you might believe it whole-heartedly, but that doesn’t stop you being wrong.

      • RedLogix 2.4.1

        If my mortgage payments and other costs exceed my rental income, then I have a cash flow problem.

        My choices in reducing order of preference are:

        1. I lower my costs. (Although the mortgage is by far the largest component and is usually difficult to reduce in the short term.)

        2. I raise my rents.

        3. I sell the property.

        Rental supply is fairly steady and predictable, although it tends to have short term peaks when the real estate market is tight as people who haven’t been able to get the price they want, take the property off the market and rent it instead.

        Rental demand is driven by immigration, affordability for first home buyers and the willingness of people to go back and live with mum and dad. While it is reasonably elastic at the margins, there is a solid core demand that either pays the rent you demand, or sleeps rough. (And there aren’t too many bridges all that pleasant to live under.)

        In the end low income people will be the people least able to either pay increased rents, OR purchase a new home even if the market is crashed. The usual outcome if prices drop precipitously is for a small group of wealthy, cashed up overseas investors swoop in and grab the bargins on offer.

  3. RedLogix 3

    Oh and Marty, if you can justify why residential rental businesses should be treated differently to all other businesses I’d be interested to see you try.

    There has been a huge amount of misinformation been out out there and lots of people, including you Marty have swallowed it rather uncritically. The simple fact is that rental businesses are treated for tax purposes exactly the same as all other businesses.

    The real difference is that banks will lend us far more money, ie allow us to leverage much more deeply, than they will allow other businesses. That is the real root of the asset bubble problem, and one I’ve long advocated stringent banking regulations around. (In particular banks should be limited to not lending more than 12 times the annual imputed rental value of a property.)

    Footling with the tax system will only introduce a whole bunch of stupid distortions, and I repeat… hurt the 40% of low income families the hardest.

  4. coge 4

    I’m with Red on this. The present system effectively subsidizes tenants rents. It can also be argued private landlords provide a more efficient service than the state. There is no real loss of revenue for the state, given that any apparent shortfall is covered through the tax the lenders pay on their credit interest.
    Also housing, despite what the Sunday papers tell us, is still mostly in decline. Thus it is more affordable than it was, so no real problem here. If radical changes are made it will be the poor tenants & the Mums & Dads with one investment property that go to the wall.

    Speaking of these investor Mums & Dads, many are now facing mortgagee sales, through their lack of financial nous. Does Bill English think they would have done better running another sort of business? Most unlikely, given the current economy.

    The present system is not perfect, but it does work.

    • Sam 4.1

      A more efficient service? How do you get to that conclusion?

      It took my landlord 2 months to replace the oven that broke and a month to get someone to fix the leaking shower, all because she wanted to save money and improve her bottom line. How is that efficiency?

      • coge 4.1.1

        Sam. If you & your landlord understood the Residential Tenancies act, or had consulted tenancy services, the problems would have been solved. Did you write your LL a ten day letter to remedy, for example?

        State housing has huge waiting lists, how efficient is that? The state does not have the resources to accommodate all renters. The state itself also rents off private landlords.

        • Sam 4.1.1.1

          I’m not the lease holder so it’s a little difficult, but that’s irrelevant. The point is that you are making the claim that is utterly absurd. Private landlords are more efficient. You’ve given no definition, no examples, nothing. Other than of course pointing out the obvious – that there is an incredible demand for housing that is more affordable than what private landlords can provide.

          Oh wait… wasn’t that what you were using to try and prove that private landlords are better?

  5. prism 5

    The base price for rentals charged is a percentage on the cost price of the house providing sufficient return to cover a mortgage at current interest, plus maintenance, taxation and return on income. This return may be foregone if the owner is looking forward to capital rise in the house price.
    If house prices are continually bid up by investors who are given taxation advantages the same as if the investment was shares, then the returns from rent may eventually fall below what provides any return. Then the landlord feels hard done by. But the pricing for the housing market has gone into bubble mode, and losses do happen then. But housing is an essential to life, not like a share which is more of a notional thing and government should not be encouraging housing bubbles – we would not want food, another essential, being priced up in this way.

    • RedLogix 5.1

      If house prices are continually bid up by investors who are given taxation advantages the same as if the investment was shares,

      The current situation allows losses in the rental business to be offset by reduced tax on other (usually PAYE) income.

      If you ring fence those losses in the rental business all you are doing is storing them up to be unwound at some time in the future when the business ultimately (often 10-15 yrs time) becomes cash flow positive.

      In the meantime the owner of the business is paying full tax on other income and has reduced personal cash flow, and is therefore no longer able to subsidise the losses in the rental business. This creates a huge short-term cash flow problem.

      Yet in the long-term the tax position is almost neutral. (Inflation comes into this.) The extra tax paid today on PAYE income, is mostly cancelled out by the losses stored up in the business and claimed in the future.

      LAQC’s avoid this undesirable and unecessary situation by effectively smoothing out the cash flow over time, but in the long term they create no real tax advantage.

      • geek 5.1.1

        And the large number of home owners like my self who have a rather large mortgage, a small baby and Mum and Dad working to pay it will probably be forced into rental properties when our equity dissapears due to tanking house prices and a bank not willing to renew a mortgage when the value of the house will not cover the loan.

        Of course when I loose my house I will be forced into a rental property owned by someone with enough equity across his houses that he can still secure finance but now has to increase his rents to cover the losses he was making on those properties Hence I am now paying more rent to pay for someone elses house. No I can’t buy a cheaper house because I made a huge loss on my current property when its value tanked and I was forced into a martgagee sale. Probably see the home go to an investor.

        Wow you’re right Marty. It realy sounds like your plan will get more families into homes. Shame about the poor buggers who have worked to get into their first homes now. But I guess the left always has been about dragging the middle down to prop up the bottom.

  6. “There has been a huge amount of misinformation been out out there and lots of people, including you Marty have swallowed it rather uncritically. The simple fact is that rental businesses are treated for tax purposes exactly the same as all other businesses.”

    Certainly it may seem that from the outside, but typically, most non-qualifying company owners don’t claim tax losses against their personal income for insufficient income generation.

    They can only claim losses for itemised expenses, such as depreciation/amortisation, interest. The idea that the difference between rent generated and the break-even point can be itemised and used as a tax loss, is largely only habitual in the residential property loss attributing qualifying company arena. As other more contemporary SMEs are crying out for locally sourced capital, it is only fair for them that the State look at closing rental specific tax shelters.

    • RedLogix 6.1

      is largely only habitual in the residential property loss attributing qualifying company arena.

      With an LAQC the owner of the business also has another income stream (usually PAYE liable). Separating out the tax position of the residential business and the PAYE taxpayer makes little sense because, in the jargon of tax experts, the business is ‘tightly held’.

      As explained above, LAQC’s are not so much a tax shelter, as a cash flow smoothing mechanism. In the long run the confer no net advantage.

      SME’s are not in the same position because there is only one income stream involved. The real problem for SME’s is their inability to source capital on decent terms… and this once again comes back to the behaviour of banks.

  7. Pat 7

    “…but that is the power of LVR ratios. And that more than anything else is what drives property prices.”

    Red L is 100% correct – it is the supply of bank funding, and bank lending policy, which drives the property market in NZ. As a mortgage broker I know this only too well. Last spring the housing market was dead simply because the Banks turned the tap off. From about May this year the housing market has kicked into gear, simply because the Banks are lending again.

    Hickey’s talk last year of “30% drop in prices”, and this year of “dead cat bounce” has proven to be utter tosh. There is only one key driver in the property market – supply of money.

  8. prism 8

    Seems that house buyers are paying more than they should considering the expected returns from rentals.That’s the bottom line. They can make independent financial decisions whether or not banks are offering finance surely. They take up the finance because they have so many handy avenues to manage the income from the property. Magazines and books have burgeoned with stories of people who own lots of houses which they have bought with negative gearing.

    When a finance company goes bust people lose money, either all or some. But they have invested because of higher returns which reflect higher risk. Investors with property have comparatively low risk, but are managing to get returns that parallel finance companies and tax benefits too. Why wouldn’t they keep pounding the pavement for properties? Property, built and speculation, and dairy farming, seem to be the major dynamic, reliable businesses in NZ. Not a good look.

  9. Pat 9

    “Magazines and books have burgeoned with stories of people who own lots of houses which they have bought with negative gearing.”

    These are now history books. You can’t go beyond 80% for a rental property, and in most cases its now 70% or less. And with “rental reliance” rules around your income being applied by Banks, you can’t load up more than 2 properties before you are hitting serious brick walls trying to build a property portfolio.

    So unless the Banks loosen the reins, the days of unbridled negative gearing are over. And therefore there is no point having a CGT.

  10. prism 10

    The party may be over for now Pat but the willingness of house buyers to use all available finance, and the banks to maximise lending is still there. If the LAQC tax limiter is itself more limited, and the banks put under some reasonable control as to lending (ie no no-deposit, 80% maximum) it would help to control the bubble float. And there is already CGT on some housing property isn’t there, if sold within a specified number of years? More encouragement for first-home buyers to save from government would surely assist the country in many ways and their savings could be matched by some ratio.

    • Pat 10.1

      “More encouragement for first-home buyers to save from government would surely assist the country in many ways and their savings could be matched by some ratio.”

      It already exists, in the form of Welcome Home Loans, and also KiwiSaver withdrawals plus the associated Housing Corp First Home Buyer Subsidy.

      The latter two will become the norm when our kids come to buy a property.

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