Ring-Fencing Rules for Rentals

New Zealand’s taxation rules have seen significant shifts over recent years, especially concerning residential rental properties. One of the critical changes is the ring-fencing rental rules, which began applying from the 2019-20 income year. These rules are crucial for property investors to understand as they influence how rental property losses can be handled.

What Are Ring-Fencing Rental Rules?

Prior to these rules, property investors could offset rental property losses against their other income, such as salary or business income, thereby reducing their overall tax liability. With the introduction of ring-fencing rules, this is no longer possible. The rules specify that losses from residential rental properties can only be used to offset income from other residential properties, not other income sources.

Key Aspects of Ring-Fencing Rental Rules

1. Losses Restriction: You can only deduct expenses for residential rental property up to the amount of income you earn from that property for the financial year. Any excess deductions (losses) must be carried forward to future years.
2. Property Types Affected: These rules generally apply to most residential properties, including those held personally or through entities like partnerships, look-through companies, or close companies. The rules also apply to property held in a trust if the trustees earn taxable income from the residential rental property.
3. Exclusions: Some properties are excluded from these rules, including:
   • Your main home.
   • Holiday homes used privately or under mixed-use asset rules.
   • Farmland.
   • Land used predominantly for business purposes.
   • Employee accommodation provided by an employer.
   • Properties that will be taxed upon sale (revenue account properties), provided certain notifications are made.
4. Global vs. Property-By-Property Basis:
   • Portfolio Basis: This default method allows deductions and income from all rental properties to be combined.
   • Stand-Alone Basis: An elective method to treat each property separately for tax purposes. Note, this method cannot be used if there are deductions common to multiple properties.

Practical Implications

Here are some implications for property investors:

• Record-Keeping: It is crucial to maintain accurate records of income and expenses for each property. This includes deciding between a global or stand-alone approach if you have multiple properties.
• Carry-Forward Losses: If your rental property operates at a loss, that loss will be carried forward to future years until it can offset against rental income.
• Sale of Properties:
  • If a property is sold and is not taxable, any ring-fenced losses remain ring-fenced.
  • If the sale is taxable, ring-fenced losses can offset the taxable gain on sale (such as tax applied to sale profits made under the bright-line test), and any remaining losses can be offset against other income types.

Filing Your Income Tax Return

To account for the ring-fencing rules when filing your IR3 income tax return:

• Residential rental deductions: Enter your total deductions for the property (or portfolio).
• Excess residential rental deductions brought forward: Enter any excess rental deductions you have brought forward from previous financial years.
• Residential rental deductions claimed this year: Enter the amount of the deductions you would like to claim for the financial year. According to the ring-fencing rules, the deductions you claim for the year should not be more than total residential income.
• Excess residential rental deductions carried forward: Keep track of excess rental deductions. These losses can be offset against future rental income. The losses will not be automatically included in your next income tax return, so it’s important to keep a record of this figure.

The ‘income and expenses for residential property’ section of the IR3 income tax return.

Case Scenarios

1. Single Property Owner: John owns a single rental property that incurs more expenses than income. His rental loss for the year is $5,000. This loss is ring-fenced and carried forward to offset rental income in future years.
2. Multiple Properties (Portfolio Basis): Mary owns three rental properties. Properties A and B incur losses, while Property C generates income. By using the portfolio basis, Mary can pool the rental income and deductions across all properties, offsetting the losses from A and B against the income from C.
3. Property-by-Property Basis: Claire owns two rental properties. She chooses to treat them on a stand-alone basis. This means the loss from Property X cannot be offset against the income from Property Y and has to be carried forward against future income from Property X itself.
4. Impact on Taxable Sales: Kevin sells a rental property. The sale is taxed (i.e. profit under the bright-line test). The ring-fenced losses from that property can offset the taxable profit, and any remaining amount can be used to reduce other taxable income.

By understanding these rules, property investors can better navigate the complexities of property investment and taxation in New Zealand. For more detailed information and specific scenarios, visit ird.govt.nz and download their IR264 Rental income guide.

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