David Hargreaves says while the move to ring-fence' investors' losses on rental properties for tax purposes appears logical we must be cautious about assuming that all the consequences will be good ones

By David Hargreaves

If something seems like a good idea, it should always be tried.

We shouldn’t, however, prejudge and just assume because something seems a good idea it will prove to be so when applied. Human nature when combined with the rule of unintended consequences can often contrive to produce unexpected results from things that seemed as if they would be a sure fire winner.

Therefore, I would counsel some caution on the Government’s moves to ‘ring-fence’ rental losses on investment properties for tax purposes.

This is a logical move and I thoroughly agree with it in principle. But I also think it shouldn’t be rushed and there will need to be some vigilance shown that there aren’t those unintended consequences.

Just as a general observation; while applauding this Government for wanting to ‘get on’ with things, I think there does need to be a balancing act between urgency and haste. I do fear that some of the measures being implemented are tipping toward the latter.

In reading the IRD’s issues paper on the proposed new moves I had the feeling, rightly or wrongly, that the paper looked a bit rushed – and that maybe not all wrinkles in the proposed policy had been ironed out. Now I guess that’s what an ideas paper is for, to test ideas and have them refined, but to my mind it’s preferable to have something put down on paper first that looks clear and definitive. And I’m not sure everything in that paper does.

For me possibly the most interesting thing in the paper is the section that talks about the decision to apply the ring-fencing on a “portfolio basis”, which means that investors would be able to offset rental losses from one property against rental income from other properties – calculating their overall profit or loss across their portfolio.

Because I think this is a fairly vital part of the new proposals, I include the IRD’s discussion of its decision here in full:

Portfolio basis
4.1 It is suggested that the loss ring-fencing rules should apply on a portfolio basis. That would mean that investors would be able to offset losses from one rental property against rental income from other properties – calculating their overall profit or loss across their portfolio.
4.2 The alternative – a property by property basis – would mean that each property would need to be looked at separately, with losses on one not able to be offset against income from another.
4.3 A property by property approach would be stricter than a portfolio approach, achieving the highest level of ring-fencing. However, it would add complexity, as losses would need to be tracked separately for each property. Moreover, a property by property approach may just result in taxpayers with portfolios re-balancing their debt funding to avoid having loss-making properties (or at least minimising the extent to which any particular property is loss-making). That response to the rules applying on a property by property basis would be inefficient, and may mean that this approach may have no real advantage over a portfolio approach – adding considerable complexity and increasing compliance costs for no real gain.
4.4 Also, a property by property approach may be seen as unfair in that if a taxpayer has two properties and breaks even on the portfolio overall, the taxpayer’s tax position would depend on whether they break even on both properties or make a gain on one and a loss on the other.
4.5 We therefore suggest that the ring-fencing rules apply on a portfolio basis, so a person with multiple properties would calculate their overall profit or loss across their whole residential portfolio.

I’m not actually convinced by all the reasoning there. 

I mean, yes, avoiding complexity is good where possible, but some of the logic here seems forced and maybe shows a government department that was in a hurry to come up with something. I’m not even really sure what the point being made in 4.4 is. Why is the scenario outlined unfair as such?

I hone in on the ‘portfolio basis’ section because I think this is the section most likely to trigger a human behavioural response – or at least be the centre piece of the behavioural response to these tax changes.

Bearing in mind every tax change always brings a human response. And it’s from this that we most need to worry about those pesky unintended consequences.

In trying to think through how people might react to these changes, it strikes me that the reaction to the ‘portfolio basis’ approach might be that investors feel encouraged to buy more properties. 

If you can’t any longer offset rental losses on the one investment property you own against other income you make in other activities, then wouldn’t there be some logic in buying more property – so that any rental losses can be offset? The temptation might be to reduce the income you get from other sources in favour of buying more property and therefore rental income and losses can be offset.

At the very least I can see this new approach leading to a bigger concentration of large, even corporate landlords. 

Maybe mums and dads with their one investment property might see it all as too much of a hassle and exit the scene. But the large landlords (possibly those large enough to have substantial investment income outside of property) may well see it as in their interest to double down on investment properties – and possibly exit their other lines of business on which they will no longer be able to balance profits against any rental losses.

I can certainly see this as one consequence of this move.

The next thing is, should we necessarily be worried? And I’m honestly not sure.

I’ve had extensive experience of renting. During that time I have rented both from ‘mum and dad’ owners and from, if you will, corporate-type landlords.

Generally I have to say that I found dealing with professional landlords to be a more consistent and generally more satisfying experience than dealing with mum and dad owners. Obviously the professionals knew better what to expect, what each parties’ rights were, and also they tended to have the people power to get jobs done.

The mums and dads I encountered (though not all of them) often tended to view owning a property as a bit of a sinecure – a bit of jam tomorrow, some easy pocket money. It meant they could get quite miffed at having to fork out money for the property or to get things done. 

So, would it necessarily be bad that such people – who possibly went into investment property ownership with unrealistic expectations – do now exit the property scene? 

Well, obviously, if a lot of them try to do it all at once – in bearing in mind these new rules might be applied as early at April 1 next year – then that might not be great for the housing market, particularly in Auckland, in the short term.

Then there’s the possibility of what happens if we do see more consolidation of property ownership in few hands – ‘super landlords’. Is there a potential for monopoly behaviour with increased rents?

Of course, on the latter point, rentals can only really be put up if the market will pay the higher ones. And if the Government does get some traction on reducing housing shortages then that shouldn’t happen.

I suppose the point is that there are potential problems here and the reaction of people and the marketplace will have to be watched closely.

This shouldn’t be rushed. If more time is needed to get an approach in place that everybody is happy with, then give it more time.

I don’t think everything needs to be done tomorrow. Just the very fact that you are tackling issues and seen to be doing so is often sufficient to get the kind of reaction you are looking for.

What the Government wants is more people in houses at reasonable prices.

What the Government doesn’t need is a housing market that in some way gets tripped up as a consequence of its actions. And with the market particularly in Auckland pretty quiet, that is possible. 

Don’t make this ‘good idea’ become bad.