The future of the complex rental market and taxes is difficult to judge, writes senior property lecturer James Young
Commentators from across the spectrum have been saying the Government has missed a prime opportunity to take the steam out of property markets by introducing changes in taxation.
And a capital gains tax has been ruled out as well as any land tax.
However, the Government did say that changes in how property improvements (ie buildings) are treated for depreciation purposes are still on the table. But what does this mean for renters and property investors out there?
No details have been given about the changes, so how can we assess how investment in property and rents could change?
Let's look for a clue within changes that have been made in taxation for residential property investment overseas.
In the midst of a property boom, Ireland introduced changes in how residential properties could be depreciated, in what items could be claimed as expenses on investment property, and in the transaction taxes on residential investments.
The result? Rents went up rapidly, as residential investors could no longer use tax structures to hold rents below the monthly costs of a typical mortgage on the same property.
Without getting bogged down in the detailed study, rents climbed from an average of 21 per cent below the mortgage costs on a similar property to 27 per cent above the average monthly mortgage costs within six months of the changes in policy.
Further, detailed research illustrated that the changes only delayed residential investment until such a point that rents were high enough to provide the required investment return. Then residential investors returned to the housing market with a vengeance - driving prices and rents still higher.
Eventually, the changes in the taxation of residential property investments were repealed because of the extreme negative consequences that the policies had on overall housing costs.
Such sweeping changes have been ruled out here in New Zealand, but possible changes in depreciation for improvements can still have a dramatic effect on rents and investment behaviour. Unlike other investments, such as shares, improvements to property require continued expenditure in order for value to be maintained.
Depreciation is one way of recognising the costs associated with maintaining value in property and other long-lived assets that become functionally obsolete over time through the tax system.
However, if depreciation is taken away entirely, then property investors will have little incentive to maintain property or incur additional expenses, unless they can raise rents to cover the total costs of the maintenance.
While the change outlined above may discourage property investors in the short-term, rents will rise from not only the increased costs associated with holding property, but from a shortage of new property investors entering the market. In the medium term, rents will increase to a point where investors are once again attracted to the residential investment market, as the rent levels rise to meet the costs associated with the changes in policy.
At the end of the day, the housing market is then left with higher rent levels that are much closer to the costs of a mortgage for the same property, and landlords looking to spend as little as possible on maintenance leading to poorer-quality housing stock for tenants.
So changes in depreciation for rental property should mean higher rents. In New Zealand, this is further complicated by the large number of small-scale property investors who hold retail and industrial property that could be affected.
There are options, however, that exist in New Zealand for changing how depreciation is used for tax purposes without creating negative consequences on the scale seen elsewhere or illustrated above.
One of these is to ring-fence depreciation so that it only can be applied to the property itself.
As things stand now, property investors can claim expenses and depreciation using a Loss Attributing Qualifying Company (LAQC) that allows investors to off-set any residential losses against any other income.
Changes in LAQCs are likely to lead to problems for other types of investment, but ring-fencing depreciation to the property itself should make the LAQC structure redundant for property, meaning that property cannot be used as a vehicle for reducing total tax liability.
While this change could still lead to increased rental rates, those increases are likely to be much less than if depreciation on improvements were eliminated entirely or if any other tax were brought in (such as the land tax or the capital gains tax).
It should be recognised that property investors provide a valuable service to the economy by providing housing and business space.
The Reserve Bank has been lamenting for years how Kiwis would rather invest in property than in shares or businesses.
By ring-fencing depreciation and expenses to the property itself for tax purposes (rather than allowing it to continually lose money on paper and offsetting that against other taxable income), property investment would then be treated as any other investment for tax purpose.
While rents will almost certainly increase as a result of changes in depreciation on improvements to property, these are likely to be less than any increase that would occur if property investors are singled out for harsher tax treatment.
One thing is certain. Issues surrounding depreciation will change how property prices and rents behave for a long time to come.
* James Young is a senior lecturer in property at The University of Auckland Business School.
