KEY POINTS:
Amid concern that increasing house prices are putting the dream of home ownership beyond the reach of many people, little attention has been paid to the obvious role the tax system plays in fuelling the property market.
The demand driving up the value of homes in New Zealand comes not only from home buyers but from those who are purchasing additional properties as rental investments.
It has long been recognised that New Zealand investors have an unhealthy attraction to the rental property market. Compared to almost all other countries, more New Zealanders invest their capital in the domestic property market, thus pushing house prices even higher.
One solution regularly suggested as a means of correcting this over-investment in rental properties is the introduction of a capital gains tax. It is often reported that New Zealand is the only country in the OECD that does not have a capital gains tax.
Despite the policy of all Governments since 1984 to expand the revenue base, for political reasons capital gains generally remain untaxed. The absence of a capital gains tax means that, except in limited circumstances, profits from the sale of rental properties are free of tax.
When compared with virtually all other forms of investment, this lack of tax provides a strong incentive for investors to put their money into rental properties.
However, what is often not recognised is that the tax-free sale is only one of the tax benefits to be gained from investing in rental properties.
While the rent received by domestic landlords is taxable, it is noticeable that rents often lag far below the value of the properties themselves. The pre-tax return to investors is often dismally low or even negative.
This apparent willingness by investors to accept little rental return on their investment can be explained by the significant tax advantages they receive.
This benefit results from the ability to claim a deduction for all expenses from the rental activity, such as mortgage interest, rates, insurance and depreciation.
In particular, expenses incurred on repairs and maintenance of the property are deductible. While a one-off, large-scale renovation would generally be treated as capital and therefore non-deductible, incremental improvements to different parts of the property remain deductible. This allows investors to improve their rental property gradually over a number of years and claim a tax deduction for the cost.
In effect, the tax law reflects the old maxim that it is wisest to buy the worst house in the best street, by subsidising the cost of improvements to the property.
With rental returns lagging behind the capital value of the properties, the deduction of expenses generally gives rise to a net loss from the rental activity. The favourable treatment of this loss is the most significant benefit provided by the Income Tax Act.
The New Zealand tax regime is almost unique in allowing net losses from this type of passive investment to be fully offset against an investor's other income. So investors can use the loss from their rental properties to reduce the tax they pay each year on their salary, wages or other income.
This general offset rule gives an immediate tax subsidy to property investors. So our tax system supports and rewards investment in rental property.
Coupled with the fact the sale proceeds of the (now improved) property are tax-free, rental properties have the most favourable tax treatment of any type of investment. No wonder so many New Zealand investors are not being put off by increased interest rates (which are of course deductible) and choose to put their capital into the property market.
Most other countries do not allow this tax subsidy of rental investments. Not only are the long-term gains from the sales of properties taxable in those countries, but any losses from the rental activity are quarantined so they may not be used to reduce tax on the investor's other types of income.
Many commentators don't recall that this restricted use of rental losses also applied in New Zealand until 1990. Rental losses incurred before 1991 were subject to specific rules so that only the first $10,000 of rental loss could be offset against other income. All losses above that sum had to be carried forward to later income years.
In effect, the losses from the rental activity were quarantined so that they could be used only to offset future profits derived from rental activities.
If the rental property never produced a profit (normally because it was re-sold before profits were generated), the rental losses would remain unused and be carried forward indefinitely. This negated the tax subsidy that currently drives taxpayers to purchase and improve rental properties.
That loss offset restriction on rental properties was removed in 1991.
While all commentators agree imposition of a capital gains tax in New Zealand is politically unpalatable, it must surely be possible to reimpose a restriction on the use of rental losses as one of the responses now being considered to rising housing prices.
* Mark Keating is director of the master of taxation studies programme in the department of commercial law at the University of Auckland.
