A fair few property investors will be quaking in their boots this week.
LAQCs (loss attributing qualifying companies) are no more. The Government isn't so much abolishing them as taking away their favourable tax status.
The LAQC has been the property investor's friend for a long time but especially since the beginning of the last boom.
The nice thing about LAQCs was that you could offset the losses on a property against tax on your day job but, once you started making a profit, it was taxed at the company tax rate.
Although the LAQC is dying, there is a replacement that some investors can choose to use - the Look Through Company (LTC).
The LTC will pass losses and or income to their shareholders, which are then taxed at the individual's marginal tax rate.
Not all landlords will choose the LTCs, says specialist property accountant Mark Withers, because it means their profits could be taxed at the 33 per cent top tax rate, instead of the 28 per cent company tax rate.
That has suddenly become more important since the Budget. More landlords will be making paper profits from their property investments thanks to the removal of the ability to claim depreciation on their buildings.
The LAQC review isn't over yet. The Government is still considering how dividends will be treated. Currently capital gains from LAQCs can be passed to the shareholders tax free as dividends.
According to the Auckland Property Investors Association, about three-quarters of members hold their properties in LAQCs, with members owning an average of 5.4 rental properties.
It was a rare residential property indeed, during the past five to eight years, that paid all the bills from rent alone, leaving a profit - unless the investor had put a large deposit down, said association president David Whitburn.
Many thousands of Kiwis set up LAQCs on the advice of real estate marketing firms, whose intent was to sell property, not necessarily to support them on an on-going basis. These people, in particular, need to make sure they've got a good accountant and possibly need additional advice about company structures.
When I researched this packaged property market in 2008, I was not impressed. Interestingly many of the companies included in my research have now disappeared, including Home Investments, Secure Invest, As Safe As Houses, Investors Forum, Housing First and, of course, Blue Chip and Merlot.
But owners who bought through these companies often knew little about how property investment really worked and are now on their own when it comes to sorting out the depreciation and LAQC changes. The properties were, by and large, comparatively highly priced because the marketing companies took an extra slice. Hence they were heavily negatively geared.
The devil is always in the detail, points out Withers. There will be a limitation of loss. LTC owners will not be able to claim losses greater than their equity in the company - which means they can't be a nominal $1 shareholder - but claim considerable losses each year.
The changes will be an administrative nightmare for investors, first choosing which type of entity to own their properties in, and then completing the paperwork.
The two groups who are worst affected are the "landlords" who were swept along and bought property even though they weren't cut out to be an investor or didn't understand how much work was involved.
The other group are the ones that pushed their borrowing to the extreme, revaluing every few months and taking equity out to buy the next property. Some of those empires are built on very shaky financial foundations, which this sort of change can undermine.
LTCs aren't the only ownership option. Some owners will favour family trusts, limited partnerships or simply holding the property as a sole trader.
Transferring the property to a limited partnership or sole trader's name comes with no direct tax cost, but require, within one year, the transfer of property titles and the redocumentation of mortgages, which will incur legal costs.
Family trusts will be taxed at 33 per cent so they may, in some cases, become less popular for holding property. On the other hand, they have the benefit of protecting the assets against business creditors or acquisitive lovers.
The rule changes make it easier for a family trust to own an LTC. In the past, it was difficult for trusts to own LAQCs.
Doing nothing about rule changes isn't an option if you're making a loss on your rental property and it is owned by an LAQC. If you do nothing, you'll no longer be able to claim losses against personal income.
You can move to an LTC or limited partnership without incurring depreciation claw back. But only if you do it within six months of April 2011.
"The first question people need to contemplate is 'does my LAQC run at a loss without depreciation'," says Withers. "If it has moved from loss to profit, this will almost certainly weigh on the decision."
In that case, an investor may want to change their LAQC to a regular company and be taxed at 28 per cent. The downside, says Withers, is that revoking LAQC status and simply returning to being a standard company means dividends paid from capital gains on property are taxable in the hands of the shareholders unless distributed on liquidation of the company.
"The risk of this, I suspect, will mean this course of action will not be favoured."
Nowhere, so far, have I seen any mention of the Relationships (Property) Act in relation to LTCs. It's probably too early for lawyers to get their claws into them.
An LTC's income, expenses, tax credits, rebates, gains and losses are passed on to its shareholders, in accordance with their shareholdings in the company.
Will the Family Court be able to rule that they're a sham and bust them open?
Because of the depreciation changes, some investors will be looking to change the shareholding of their LAQCs when they move to LTCs or other structures.
Changing ownership percentages shouldn't be done without taking legal advice about the relationship property consequences, Withers says.
The LAQC may have been set up with the husband owning 99 per cent of the shares so that the losses could flow through to his day job and the lower-earning wife the other 1 per cent.
Now that artificial losses from depreciation are gone, the ownership structure is doing exactly the opposite of what it was intended to do - it's funnelling the profits to the husband, who is paying tax at the highest rate.
The legislation for the new rules is expected to be enacted before the end of this year and will come into effect from April 1, 2011. They will apply to LAQCs from the income year starting on or after that date.
Ending on a positive note, Withers says most property investors he acts for will be able to absorb the depreciation changes and are not in financial difficulty.
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