Gareth Morgan: Band-Aid treatment avoids real problem

Some property investors are using the rental losses to push their income down so far they can claim the Working for Families benefit. Photo / APN

A Herald article by Andrew King of the Property Investors Federation claimed that property is already taxed the same as any other investment, that the Tax Working Group failed to make that clear in its report, and that any moves to have special tax treatment of residential property would be discriminatory.

King is absolutely correct - property investment is taxed the same as investment in local shares or in any other business.

The income is taxable, expenses in procuring that income, including rates, repairs and maintenance, depreciation and interest are all tax deductible, while the capital gain (so long as the investor is not in the business of trading property) is tax free.

The working group was informed by the IRD that the $200 billion rental property sector "lost" $500 million in 2008.

Therein lies an issue insofar as those of us interested in the effective tax burden are concerned. Absolutely it is the case that when a business is starting up it can make tax losses for a period before it moves into a profit and starts paying its fair share of tax.

But the rental property market doesn't do that. Year after year the whole sector makes tax losses - proof that this is not any "normal" type of business.

Indeed the working group report said that for residential rental properties "income, in the broadest sense ... is being systematically under-taxed".

So what's up? King knows full well that owning a residential rental and running it at a loss is the easiest way there is to reduce the tax burden on your other income. In other words many of us are in the residential rental game specifically to make a taxable loss.

The figures bear that claim out - to the extent of a $500 million annual loss of taxable income for the whole sector. In short, it's the best rort of the tax system there is, and the mums and dads are into this, like rats up a drainpipe.

Now let's be clear, nobody is doing anything illegal and folks are being perfectly rational, it's just that applying to property the same tax rules as to a business or shares seems to have been a particularly dumb policy by governments over the years.

For one, it has cost them heaps in tax - and that's not the only cost to the economy, the misallocation of investment money has been astounding.

The relevant question to ask of the property rental game - when is a business not a business? - hasn't been asked by past governments, they being too politically cowered by the ballot box implications of curbing the national pastime of exploiting the rental property "tax dodge".

So why, if residential property investment is taxed the same as shares or any other business, is it a tax rort? If you were to include capital gains in the profit measure you would instantly see that residential landlords aren't running at a loss at all - their core business is capital growth.

And that of course isn't taxed. So the root of the problem is that capital growth in property is by far the main component of the "profit" line of this business and it's not taxed.

Indeed the tax data tells us it is all of the profit, net rental yields, once you take account of gearing costs, being negative.

Some are even using the rental losses to push their income down sufficiently so they can claim the Working for Families benefit. About 9700 such families are out there doing that. If you're not and you could, you're a mug.

Now the working group has recommended a Band-Aid fix to the problem. As with all of its recommendations, it avoided going to the root cause of the problem and suggesting that be corrected.

Rather, it stayed "safe" and confined itself strictly to tax policy responses only, leaving welfare policy and other policy causes of tax system failure, outside of its recommendations.

This is why I gave it 4 out of 10 for the quality of its work. The limp response of a tax fix as the way to address this issue is easy to criticise and King does that admirably, claiming quite rightly, discrimination against his members.

The tax fix options suggested by the working group include depreciation on residential property not be claimed as a deduction for tax, that rental losses be ring-fenced and not used to offset tax on other forms of income or that a completely different tax regime (the risk-free rate of return system) be applied to rental property.

Now you can just imagine the response of virile tax dodgers to these types of boundary-specific measures - they don't bear thinking about. Yet we run a real risk that this year's Budget will bring down such a ham-fisted policy response.

* Gareth Morgan is director of Gareth Morgan Investments.