What taxes do property investors need to pay?

Property tax is a complex beast. It’s ever-changing, tricky to negotiate and littered with fishhooks investors can potentially get caught on that can leave you with an unexpected tax bill.

This article outlines the core taxes New Zealand property investors are subject to, along with some of the tactics you can use to minimise the amount of tax you have to pay.

Please note: Even confident investors rely on the advice of specialised property accountants to help manage their portfolios.

What are the taxes I need to pay as a property investor?

First things first: If your property makes a taxable profit, you will need to pay income tax. The entity you own your property in will determine what this rate is.

Trusts currently pay tax of 33% and limited liability companies pay 28%. Meanwhile, if you own your property in your own name or in a “look through” company, your tax rate will depend on what you earn.

In the latter two cases, any extra dollar you earn is charged at your marginal tax rate.

As of April 1, 2021, marginal tax rates for each dollar of income you earn are:

• Up to $14,000 per annum (10.5%)
• Over $14,000 and up to $48,000 (17.5%)
• Over $48,000 and up to $70,000 (30%)
• Over $70,000 and up to $180,000 (33%)
• Remaining income over $180,000 (39%)

To give an example, let’s say you earn $40,000 a year and your property earns a taxable profit of $5,000.

If you own your property in a trust, then you will pay $1,650 in tax (33%). If you own it in a limited liability company, you will pay $1,400 in tax (28%).

And if you owned it by yourself in a “look through” company or in your own name, then you would be taxed at your marginal tax rate (17.5%). That means you would pay $875 in tax ($5,000 x 17.5%).

This basic example should give you a sense of why choosing the right tax structure is important, because how you choose to own your properties will determine how much tax you have to pay.

How does the new interest deductibility changes affect how much tax I pay?

Most property investors will pay more tax from 2021 onwards, following a recent government change to interest deductibility.

This is because it affects how interest costs are treated when calculating your property’s annual income tax bill.

When calculating your investment property’s taxable profit pre-October 2021, you would include your interest costs as a taxable expense.

In future, your interest costs won’t count towards that profit calculation. So your property will appear to be more profitable in the eyes of the IRD. Because the calculated profitability has increased the amount of income tax property investors have to pay will also increase.

The amount is sizeable, enough to turn a positively-geared house into a negatively-geared one.

For instance, let’s continue with the above example where a property had a taxable profit of $5,000. Let’s now assume that the property had interest costs of $15,000 and the property is held in a trust – so attracts a tax rate of 33%.

After interest deductibility is fully phased out, these $15,000 of interest costs will no longer be tax deductible. That will increase the property’s taxable profit from $5,000 to $20,000.

That means that the level of tax increases from $1,650 ($5,000 x 33%) to $6,600 ($20,000 x 33%).

The property used to provide the investor with an after-tax passive income of $3,350 ($5,000 - tax of $1,650). Now the property’s after-tax position will be -$1,600 ($5,000 - $6,600).

What is the bright-line tax?

The bright-line test is New Zealand’s lite-version of a capital gains tax.

A capital gains tax is a blanket tax for property transactions, which is paid regardless of how long a property has been held for, or how much gain the owner has made.

The bright-line tax is similar but only applies to properties owned for less than 10 years, which aren’t your main home.

It also takes into consideration the incurred costs of things like real estate fees, renovation costs, or buyer-agent fees, and charges tax on the leftover amount of gains from selling your property.

For instance, let's say you bought an investment property in June 2021 for $500,000. You then sell it 5 years later for $700,000. Because you sold it within the 10-year bright-line period, you need to pay tax on the gain of $200,000 ($700k - $500k).

Let’s also say in selling the property you paid $25,000 in real estate agent fees and $25,000 in renovations. That means that you spent $50,000 in total.

The gain you are taxed on, $150,000 ($200k - $50k) is taxed as income.

If you owned this property in a trust your tax rate would be 33%. That means you would pay $49,500 in tax.

So, it’s not a capital gains tax, per se, but still doesn’t mean all capital gains are tax free.

It’s important to know that the bright-line test doesn’t apply to:

• Your main home
• Any inherited property
• If you sell the property after 10 years
• Commercial property or farmland

Currently, New Zealand doesn’t have a capital gains tax and is unlikely to see one in the near future, according to Jacinda Ardern, which is good or bad news depending on which side of the social spectrum you land on.

How do I factor in council rates?

Local council tax rates, commonly known as just rates, are paid directly to local councils and are different depending on where your property is in New Zealand.

That’s because we currently have 67 different territorial authorities (councils) around the country. Each sets its own rates – some are higher, some are lower.

But just because rates are lower in one area doesn’t mean investors are always better off in terms of tax.

That’s because it’s not the total amount of tax that matters, but how high those tax bills are compared to rents within the area.

For example, Grey District has the cheapest rates in dollar terms, at $1,739 per year. But rents are so low it will take 5.9 weeks of the average rent to pay them.

But if you invest in a rental property in Lower Hutt, yes the rates are higher but so are rents. In that area it only takes 4.6 weeks of rent to pay off the rates.

Generally speaking, investors will find lower council rates in areas that have fewer people living in a city or district. That often also means lower rents.

Check out the infographic below to explore where council rates are lowest for property investors.

Of course, there are exceptions to the rule. And it’s good advice for property investors to research the data, and also factor in all essential costs you’ll pay as an investor, not rates on their own.

How can I decrease the amount of tax I have to pay?

There are two key ways investors can limit the amount of tax they have to pay. Firstly, depreciating their chattels correctly. Secondly, by using the right ownership structure for their situation.

Chattel depreciation

Over time parts of rental properties become worn out and need replacing. These are called chattels. And the decrease in value is called depreciation.

If it’s not nailed down, glued in, or directly part of the building, it’s a chattel and you can depreciate it.

This includes letter boxes, carpets, curtains, light fittings, appliances and even driveways.

Investors who depreciate the chattels of their rental properties can use this as a way to minimise the amount of tax they pay.

For instance, if you own a property that has $50,000 of chattels, you could save as much as $16,500 in tax (over time), if on a 33% tax rate and depreciating the chattels correctly.

This is a commonly misunderstood area of residential property tax. That’s because in 2011 the then-National government stopped investors from being able to depreciate the value of their property buildings.

Some non-property accountants don’t realise that investors can still depreciate chattels within the building. This ultimately leads to their clients paying up to $16,000+ more in tax over time.

Ownership structures

It’s important investors don’t pay more tax than needed. But, if you own your properties in the wrong way, you will almost certainly overpay.

Ownership structures, or how you choose to own your property, have a big part to play in minimising this amount of tax paid.

Usually, most investors will choose one of the following structures:

• Hold property in your own name
• Set up a trust
• Use a “look through” company (LTC)

Each structure comes with its own tax pros and cons, and each will be the best structure for different people.

You won’t realise how individual your situation is until you talk to an accountant. So it is in your best interest to get advice so you don’t inadvertently set yourself up to pay more tax than you have to.

Trust

A trust is a separate legal entity, which owns assets on behalf of beneficiaries (usually you).

These can be useful for higher-income earners. That’s because the top income tax rate is 39%, whereas the trust tax rate is 33%. So structuring properties in a trust leads to a lower tax rate.

Look Through Company (LTC)

A Look Through Company (LTC) is a very useful restructuring tool, because it takes on the tax rates of its shareholders.

This means that couples can direct any profits towards the lower income earner and pay a greater proportion of the property’s profits on the lower income earner’s tax rate.

Holding property in your own name

In this instance, profits and losses go out to you individually. But there is very little tax flexibility and unlimited liability.

However, it is the cheapest ownership structure to form and administer, because you don’t have to set up a new entity or file annual returns for that trust or company.

This is usually the right structure to use when investors have simple tax affairs, are purchasing on their own, and if they don’t already pay the top personal income tax rate (39%).

Example

Remember the example above of a property investor earning $40,000 a year and the property earning a taxable profit of $5,000.

The trust pays $1,650 in tax (33%). While, owning the property in a “look through” company or in the investor’s own name, would only attract $875.

Therefore the investors pays $775 less per year in tax if owning the property in their own name vs a trust. There are real tax savings in choosing the right ownership structure.

How important is a property accountant?

Property tax is complex, and as a discipline it is the hardest it has ever been, so it’s a very wise decision to use an accountant who specialises in property.

Any accountant can file your tax return, but you really want to work with an accountant who can give you good advice about how to minimise the amount of tax you legally have to pay.

It’s also important to treat your property investing as a business. And most property investors don’t realise that they own reasonably sized businesses. For instance, an investor with 3 to 4 properties in Auckland will have more invested in their portfolio than what’s invested in most small businesses.

Think about it: Most Auckland properties are worth over a million dollars. So if you have 4 properties, you might have $3-4 million worth of debt. You’re running a decent-sized business.

So it’s a good idea, from a conceptual mindset, to treat your property investment like a business. Set up a good structure, keep good records, and keep a good accountant who specialises in what you need.

If you need a recommendation, Opes Partners has reviewed the Top 5 Property Accountants in New Zealand.

What are some of the fishhooks?

There are a few situations where investors can trip up on the bright-line test and get caught with unexpected tax.

Firstly, let’s take the first exclusion: You don’t have to pay tax on your main home.

This is true. But we have an intention-based system in New Zealand. If you intend to flip a property for a profit then you have to pay tax.

Sure, if it’s a one-off, and you decide to renovate and sell your home after two years you won’t pay tax on the gains. But, keep doing it (twice in any two-year period) and the IRD will see this as an established pattern and consider it your intention to buy and sell for profit.

This means the IRD will come looking for their tax on the gains of all your properties, at the rate of your income tax rate, which could be 39% for higher-income earners.

Secondly, your main home may not always be fully exempt from the bright-line test after the latest round of changes.

The main home exemption only applies to the time that you actually lived in the property. That means that if you buy and sell a property within 10 years after March 2021, and you used it as a rental (even for a short time), you will have to pay some tax.

For instance, let’s say you buy a home in April 2021. You live in it for 2 years, rent it out for another 2 years, then move in for a final year before selling for a $100,000 profit.

Under the previous rules the entire profit would be tax free. However, under the new rules you will pay tax on the time you rented the property out.

In this example you lived in the property for 3 years (60%) and rented it out for 2 (40%). So you would need to pay tax on $40,000 of the profit. If your tax rate was 33%, then you would pay $13,200.

Thirdly, inherited properties still need to be considered. Say for instance you inherit a property with your sister, and you buy her out for her share and then sell the property as a whole within the 10-year bright-line test. You must pay tax on any gains on the share you have bought.