What do the accountants say?

The below information has been put together in partnership with Kendons, Business Advisors & Chartered Accountants.

 

Lance Edmonds | Director | Kendons Scott MacDonald Ltd, Chartered Accountants, Christchurch


 

We are a proactive chartered accountancy firm. We work closely with business owners to help them achieve their goals and to improve their business profitability and performance.

Our core services include – company and trust formations, business structures, business and strategic planning, succession planning, growth management strategies, risk management strategies, budgeting and cash flow forecasting, developing and implementing performance improvement strategies and measurement systems (including benchmarking against industry standards), management accounting, and advice on business valuations.

We also provide the traditional accounting and taxation compliance services – namely preparing annual financial statements and associated income tax returns.
 

Presented by Lance Edmonds, CA


 

Contents
 

Introduction
 

Structures

 

Tax Rates 
 

Income and Deductions 
 

Examples


Key Issues



Introduction

Lance Edmonds is a Director of Kendon’s Scott Macdonald Limited (Kendons) and commenced his career with Kendons in 2007 as a Senior Accountant in the Business Advisory Team. He progressed to Manager in 2008 and then became an Associate in 2012 and finally an owner/director in 2014. Lance previously worked for a large well known accounting firm. Lance has developed specialist expertise in a number of areas including – business planning, acquisitions and disposals, succession planning, budgeting and cash flow forecasting, capital and debt funding (including the raising finance for business start-ups), due diligence reviews, trusts, asset protection, improving business performance (business turnaround), special projects, and governance and internal control reviews. He also has substantial taxation expertise.

Lance has experience in a wide range of industries including – property investment, general manufacturing, hospitality, property development, service, wholesale, e-commerce, forestry, retail, transport, building and finance.


 

 “…property investors stand a much greater chance of being subject to an audit today than they did in the past”

    • Commissioner of Inland Revenue


 

Deciding how to own an investment property has important tax consequences, so it pays to get it right from the start. The first step is to make sure that when you sign a Sale & Purchase Agreement for a new property, that you have the option of deciding later what entity will own the property. If you simply put your own name on the Sale & Purchase Agreement then it has to be owned by you personally.

 

This is not always an ideal situation. Especially, if you subsequently decide you want to put it into a trust or company, as this will result in additional legal fees to change the ownership. A way around this potential problem is to always make the purchaser your name “… and or nominee” on the Sale & Purchase Agreement. This gives you the option to nominate the entity which will own the property at a later date. You can even go unconditional on the purchase of the property and decide on the entity before settlement. Thus allowing you time to check with your accountant.

 

Furthermore, you also have time to set up your trust or company, depending on which structure is best for you.

 

Structures

 

We believe that one of the most important aspects in acquiring a property investment is to ensure that the most appropriate structure is chosen.  It is this structure that will give rise to the ultimate taxation treatment of your investment. We believe that you should consider the following options in respect of the chosen structure, namely:

 

  • Company

    • Look Through Company

  • Trusts

  • Partnerships and Special Partnerships

  • Sole Traders

 

Company 

 

A company is a separate legal entity that generally has the rights and obligations of a natural person.  The company’s decisions are generally made by its Directors. The most common form of company is a limited liability company.  Limited liability is where the company is responsible for the business debts and obligations, rather than the people who own the business.  However, the limited liability advantage is reduced where the owners provide personal guarantees to banks and suppliers in respect of the company’s obligations.

 

The advantages of utilising a company structure include:

 

  • Perpetual succession: The continuance of a company is not affected by the death or withdrawal of shareholders or directors

  • Shareholders may have varying entitlements to dividends and/or control

  • Ownership and management can be separated

  • Tax planning opportunities are available through allocating income to shareholders (through the use of hindsight), the tax treatment of dividends, and the timing of some payments

  • Funds can be borrowed using a charge over the company’s assets (called a debenture)

  • Shares can be acquired without interfering with the corporate structure or ownership of the underlying assets.  This maybe useful in reducing the exposure of tax consequences that may result from the sale of assets.

 

The disadvantages associated with the company structure include the cost of incorporation and the ongoing administration (for example book keeping and reporting requirements).

 

A company is a taxpayer in its own right and the corporate tax rate is 28%.  Income can be allocated to shareholders/employees to remunerate them for services provided.  This income is taxed at the shareholders own marginal tax rates. 

 

Tax losses generated by companies can be carried forward and offset against the future income, provided that 49% of the shares are continued in the same ownership as when the loss was derived. (please refer to Ring Fencing of Losses in the key issues section)

 

 

Look Through Company (LTC)

 

An LTC is a company that will be taxed as a limited partnership. All profits and losses of an LTC will be attributed to shareholders in accordance with their shareholding interests. 

 

Points to note:

  • Advantage of LTC is that any losses are able to be distributed to shareholders

  • The shareholders can then build up losses in their own personal names and these can potentially be utilised in the future against rental profits only (please refer to Ring Fencing of Losses in the key issues section)

  • Disadvantage any profits from the company are distributed to shareholders and taxed at their marginal tax rates which could trigger the higher marginal tax rates (30% and 33%)

  • Limitations on allocating shareholders salary’s 

  • Limited liability but shareholders liable for any income taxes that the company defaults on

  • Common structure for rental properties incurring losses 

  • Cost associated with incorporation of the Company and filing the LTC elections

 

Trust 

 

A trust has no legal definition and is often referred to as a ‘living will’ as it operates whilst you are alive. The term trust refers to the legal relationships created by a person ‘a settlor’ when assets have been placed under the control of a trustee for the benefit of a beneficiary or beneficiaries.  A Trust Deed is a legal document that documents the various rules and requirements that the trustees must follow in order to operate the trust.

 

We believe that the primary advantage of establishing a trust is to protect assets which are both currently owned and which are to be accumulated in the future.  It takes a long time to build up a substantial asset base whilst it only takes one small event for your assets to diminish or be lost entirely.

 

The trust should hold assets which are likely to increase in value.  These assets should be transferred to the trust providing that there are no major costs making it uneconomical to do so.  Assets which are not likely to increase in value are not usually transferred to the trust.  These assets could include motor vehicles, low value boats and home contents.

 

Assets which should be considered to be transferred to the family trusts include:

 

  • Family home 

  • Holiday home

  • Shares, units, cash deposits, bonds, etc

  • Antiques

  • Commercial and residential property

  • Loans to family members

  • Shares in private companies

 

The advantages of utilising a Trust include:

 

  • Flexibility in the distribution of income to beneficiaries

  • Income can be allocated without IRD approval

  • Lower compliance costs compared to Companies (but higher than sole traders and partnerships)

  • Ability to distribute Capital Gains tax free 

  • Protection of Assets 

  • Common structure for rental properties making a profit 

 

The disadvantages of utilising a Trust include:

 

  • Trusts cannot distribute losses

  • Losses carried forward to offset future income (please refer to Ring Fencing of Losses in the key issues section)

 

The only existing disadvantage is that it is the most costly structure to establish.  However, a trust is only used where the advantages outweigh the establishment costs.


 

Partnerships

 

A partnership is another common form of business structure which is commonly used in cases where the property investment is owned by a Husband and Wife.  A partnership has limited formalities and does not require any legal documentation. Instead a partnership (in the absence of an agreement) is governed by the Partnerships Act 1908.

 

Like the sole trader, a partnership is not a separate legal entity, although some organisations recognise its existence (for example the Inland Revenue Department requires a partnership to file returns of income).  Given that a partnership is not a separate legal entity, there is no separation of personal assets from business debts.  In fact in a partnership the respective partner’s personal assets are subject to decisions made or liabilities incurred by the other partner(s).

 

Again, as we suggested above the exposure of the personal assets to the risk of the partnership can be reduced by utilising a family trust structure, but this will usually require the element of time.
 

Other disadvantages of utilising the partnership structure include,

 

  • Unlimited liability to business debts

  • Potential problems relating to the retirement and admission of partners

  • Potential for termination on the event of disputes

A partnership is not a separate tax paying entity (although the partnership must file a return of income). Each partner is taxed on their own proportionate amount of income and expenditure, even if it results in a loss.  In all other respects the tax treatment of the partners is the same as a sole trader.

 

  • All income/losses must be distributed to partners

  • Partners personally liable for all partnership debts

  • No asset protection

  • Limited partnerships (expensive to setup)

  • Partnerships – Profits/Losses flow through to partners automatically and taxed at their personal marginal tax rate

 

Individuals (Sole Trader)

 

The sole trader structure is the most common and simple form of trading structure.  The individual bears the responsibility for owning and operating the business. They are entitled to all the profits derived by the business, and conversely are liable for the losses incurred.

 

The sole trader is not a separate legal entity and is subject to legislation which covers general business, including:

 

  • Income Tax Act and Goods and Services Tax Act

  • Fair Trading Act

  • Resource Management Act

  • Employment Contracts Act

  • Consumer Guarantees Act

  • Health and Safety Act

 

Because a sole trader is subject to the above, and is liable for any losses incurred by the business, they bear all the risks associated with the business activities.  In our view this is the major disadvantage of this structure.  At risk is all other property which is held by the sole trader. These assets would be required to be sold to repay any shortfall in assets upon liquidation or disposal of the business.

 

We should also point out that the personal and investment assets may be protected from the business activities by the use of a family trust.  We strongly suggest that you pursue the use of a   family trust.  The use of a family trust will only mitigate the exposure of the personal and investment assets rather than completely protecting such assets.
 

A sole trader is taxed in the hands of the sole trader at the following tax rates:

 

  • 10.50% on income up to $14,000

  • 17.50% on income over $14,000 but less than $48,000

  • 30% on income over $48,000 but less than $70,000

  • 33% on income derived above $70,000

 

Generally there is no ability to divert income; however some income may be channelled to a spouse provided that Inland Revenue Department approval is sought.  Tax losses that may be incurred are carried forward to be offset against future income (whether business, wages, salary or from investment income).

 

In general individuals benefit from receiving losses under own name which reduces their taxable income and any overpaid tax will be refunded. Please note rental investment losses are now ring fenced and cannot be offset against other income (please refer to Ring Fencing of Losses in the key issues section).

 

If rental property is creating a profit and the individual’s income is greater then $48,000 any additional income will be taxed at 30 or 33%. If this is correct it may be beneficial for the property to be held in a Trust or Company (not an LTC). 

 

Summary of Structures

 

If asset protection is your main objective then a trust may be the best structure. But keep in mind that losses cannot be distributed from a trust to beneficiaries. If you’re primary source of income is from wages or a salary you probably wouldn’t want to own an investment property in a trust as it is unlikely you will be able to off set the losses against your income and thereby obtain a tax refund.

 

The main thing is to select the best structure which suits your needs and makes the best use of any tax advantages where possible. You should seek advice regarding your new property purchase from professional advisors. 

Tax Rates for the 2018/2019 Year

 

Personal Tax Rates

INCOME

 

2018-2019

$0 - $14,000

10.50%

$14,001 - $48,000

17.50%

$48,001 - $70,000

30.00%

$70,001+

33.00%

 

Companies: 28%

Trusts: 33%
 

Income & Deductions

 

Income 

 

Examples of typical income:

  • Rental Income

  • Depreciation Recovered  - When property is sold and a gain on sale results, depreciation recovered is the lower of the depreciation claimed over lifetime of asset and profit on sale (unlikely to be a significant issue going forward due to changes in the depreciation rules for residential buildings)

 

Expenses

 

Examples of typical expenses:

  • Bank Fees

  • Insurance (house and contents)

  • Interest 

    • Incurred on loans used for rental property (see key issues on maximising your interest deduction)

  • Rates

  • Motor Vehicle Expenses

    • If incurred for purpose of rental property E.g. Driving to property for inspections, driving to Mitre 10 to buy paint for the property

 

Two Options

    • Actual Running Costs  –  Required to keep log book for minimum of three months to determine actual business use and can claim petrol, repairs, WOF, registration, etc at actual running cost %

    • Mileage Claim – Mileage 

      • IRD set rates  per kilometer

      • Keep a record of how many Kilometers travelled during year

  • Repairs and Maintenance (R&M) 

    • Costs must be R&M

    • Substantial improvements or alterations are not R&M and must be capitalised 

    • Must be work that is carried out to return property to original state when purchased e.g. replacing taps, most paint work, plastering holes in walls 

  • Low Costs Assets < $500

  • Home Office 

  • Depreciation

    • Depreciation on chattels, plant & equipment at IRD approved rates 

    • Land – No depreciation available

    • Buildings – 0% depreciation

    • Valuation of land, buildings, chattels 

    • Chattels – higher depreciation rates available 

    • To depreciate separately chattels must be separate assets and not permanently attached to building e.g.

      • Carpet, blinds, dishwashers – Separate Assets 

      • Doors, plumbing, wiring  – Part of the building

Key Issues (example)

  • Family Home Converted to Rental Property – It’s quite common for the original family home to be retained and converted to a rental property and in a lot of cases have minimal debt over the property. The new property purchased becomes the new family home. If the new property purchase is to be debt funded then you are likely to want the debt to be over the rental property to maximize the interest deduction. However, under specific tax rules you are limited to the original debt over the original family home loan.  

    • This is a common trap for a number of investors. To get an interest deduction, the money you borrow must be used for income-earning purposes (i.e. deriving rental income). In this case, the money borrowed is to buy a private residence. Even though you will be securing the borrowing against a property which is deriving rental income, this will be irrelevant when you come to claim your deduction. 

    • One option for securing a deduction would be for the first property to be purchased by another entity, say, a family trust or company. The sale proceeds could then be used to purchase the family home. If the entity borrows funds to purchase the property, it should be able to claim a tax deduction for the borrowing costs because the borrowed funds would have been used to purchase an income-producing asset.

  • Related Party Transactions – If you plan to transfer your rental property into another structure e.g. Family Trust then the transactions must be at market value and this also limits the depreciation claim the Trust can claim

 

  • Property/Rental Investors – Any personal property acquired by a person for the “purpose of resale” and resulting profit will be taxable or loss deductible regardless of whether the transaction was a “one off” transaction

 

  • Property Development – Developing rental properties can leave the entity or individual tainted as a ‘property developer’. There is the potential for profits on sale of properties can potentially be taxed

 

  • Airbnb and mixed use assets - Using Airbnb and similar platforms to rent a spare room or holiday home has become increasingly popular. Summarised below are various tax and other consequences associated with Airbnb.

 

The key consideration is that any money received from renting a room or home is taxable income. Note the following:

  • various costs may be deductible from that income - however, where you are also using the property, the mixed-use asset rules may apply to prescribe the manner costs are apportioned between deductible (income-earning related) amounts and non-deductible (private) amounts

  • a mixed-use asset is where, during the tax year, it is used for both “private use” and “income-earning use”, and it's also unused for 62 days or more

  • the mixed use asset rules apply to properties owned by individuals, partnerships, look-through companies, trusts and other close companies and therefore capture the most common investment or asset protection vehicles used in New Zealand

  • even where the mixed-use asset rules do not apply, a reasonable method for apportioning expenditure will be required.

 

Note that “private use” and “income – earning use” are defined below:

  • “private use" of a mixed-use asset means use by you, your family or associated people, whether you receive income from the asset or not,  or use by non-associated people if you receive income at less than 80% of market rates (income received for private use is exempt income and expenses for private use are not deductible)

  • "income-earning use" of a mixed-use asset means use by a non-associated person who pays you at 80% or more of market value.

 

There are also GST considerations, as renting a room or home on Airbnb for short-term stays is potentially subject to GST.

 

Note the following:

  • if you are not registered for GST, income you earn from Airbnb, either on its own or in conjunction with other income you earn, may take you over the threshold for compulsory GST registration

  • GST registration is compulsory where a taxable activity is being carried out and annual turnover exceeds $60,000 or more

  • if you are already GST registered you will need to account for GST on the money you receive from letting through Airbnb (if you are required to register for GST, the property has now been brought into the GST net, meaning GST may need to be accounted for on the sale of the property).

 

Other factors to consider include the following:

  • insurance and whether the insurance policy provides cover whilst  the property is rented

  • local government requirements such as notifications or consents, along with any impact on rates.

 

Whilst it is a straight forward process for you to rent a property on Airbnb, it is equally a straight forward process for the IRD and local councils to monitor your activity.

 

  • The “bright-line” test – which will be applied to properties bought and sold within five years (from 29 March 2018) Prior to this the two year rule applied, which was introduced 1 October 2015. This means that a residential property sale could now be taxable even if the seller did not acquire the property with the intent to resell or if they have to sell due to circumstances outside of their control. However, there are some exceptions to the rule. These are when the property is the main home of the seller or, in certain circumstances like inheritance, or transfer in a relationship property settlement.

 

A taxpayer’s ring-fenced residential rental or other losses from one year could be offset against their residential rental income from future years.

 

Conclusion

 

The above issues are complex and we highly recommend seeking advice from a chartered accountant for further advice/details and structuring of the transactions to insure you can maximize the deductions.

 
 
 
 
 

PO Box 9321

Waikato Mail Centre

Hamilton 3240

116 Main Highway, Ellerslie 

0800 677 777

info@journey2.co.nz

© 2020 Journey2 Ltd. Website by Motion Digital