Tax and Property: Understanding Ring-Fencing Rules for Rental Losses

The New Zealand tax landscape for rental property investors has undergone significant changes in recent years. One of the most impactful changes is the introduction of ring-fencing rules for rental losses, which fundamentally alters how property investors can use losses from their rental properties for tax purposes.

What Are Ring-Fencing Rules?

Residential Rental Ring-fencing rules prevent rental property owners from offsetting losses from their rental properties against other sources of income, such as salary or wages, when calculating their taxable income. This represents a major shift from previous tax treatment where rental losses could be used to reduce overall tax liability across all income sources.

However, the rules aren’t entirely restrictive. Property owners can still:

• Carry forward losses to use against future income or profits from the same property
• Use losses from one rental property to offset income from other rental properties in their portfolio
• Eventually use unused deductions against other income when properties are sold (under certain conditions)

Which Properties Are Subject to Ring-Fencing Rules?

The New Zealand ring-fencing rules apply specifically to ‘residential rental property,’ which includes:

Land with existing dwellings: Any land that currently has a dwelling on it falls under these rules when used as rental property.

Land with planned dwellings: Property where the owner has made arrangements to build a dwelling is also covered.

Bare land with development potential: Land that could be used to build a dwelling under the relevant operative district plan is included.

Commercial accommodation businesses: Property used predominantly in accommodation supply businesses (including short-term rental platforms like Airbnb and Bookabach) where the dwelling isn’t the owner’s main home.

Important Exemptions to Ring-Fencing Rules

Several types of property are specifically excluded from the ring-fencing rules:

Business premises and farmland: Properties used predominantly as business premises or farmland are exempt from these rules.

Main homes: A person’s primary residence is not subject to ring-fencing, even if occasionally rented out.

Mixed-use assets: Properties subject to mixed-use asset rules, such as baches used both privately and as rentals, are excluded.

Widely held companies: Land owned by widely held companies falls outside these rules.

Employee accommodation: Properties provided to employees or workers due to remote location requirements are exempt.

Revenue account properties: Land identified as taxable on sale (including properties held for dealing, development, subdivision, or building businesses, and land purchased with resale intention) can be exempt, provided specific notification requirements to Inland Revenue are met.

Portfolio vs. Property-by-Property Approach

Portfolio Basis (Default Method)

For investors with multiple rental properties, the default approach applies ring-fencing on a portfolio basis. This method allows investors to:

• Offset deductions from one rental property against income from other rental properties
• Calculate overall profit or loss across their entire property portfolio
• Potentially use unused deductions against other income when all properties in the portfolio are eventually sold (if all were taxed on sale)

The portfolio approach offers flexibility and administrative simplicity for multi-property investors, as it allows losses from underperforming properties to be offset against profits from successful ones within the same portfolio.

Property-by-Property Election

Investors can choose to apply ring-fencing on a property-by-property basis by notifying Inland Revenue in their income tax return. Key aspects of this approach include:

Election timing: For the 2019-20 income year and beyond, investors must make this election in their tax return. For properties acquired after 2019-20, the election must be made in the tax return for the year the property is purchased.

Detailed reporting: This method requires setting out income and deductions for each specific property separately in tax returns.

Future offset opportunities: When a property is eventually sold and the sale is taxed, unused deductions can be used to offset other income, including salary or wages.

Limitations: Unused deductions transferred from another property cannot be offset against other income if the disposal of the original property wasn’t taxed.

Complex Ownership Structures

Transfer Between Companies

For investors operating through multiple companies within a wholly-owned group, rental losses can be transferred between companies. However, the receiving company can only use these deductions against:

• Residential rental income
• Sales of residential land that are taxable

Interposed Entities

The legislation includes specific provisions to prevent avoidance of ring-fencing rules through complex entity structures involving companies, trusts, partnerships, and look-through companies.

The avoidance scenario: Without these rules, an investor could potentially borrow money to buy shares in a company that purchases residential property, then claim interest deductions on the loan as an investment in shares rather than rental property, avoiding ring-fencing restrictions.

Residential land-rich entities: The rules target deductible interest on funds borrowed to acquire entities where residential land comprises more than 50% of assets. This includes:

• Close companies
• Partnerships
• Look-through companies
• Trusts

Interest limitation: Borrowers are limited in how much interest they can deduct, with any portion exceeding rental income from the property being ring-fenced and carried forward to future years when the person receives residential income.

Strategic Considerations for Property Investors

Cash Flow Impact of Ring-Fencing Rules

Ring-fencing rules can significantly impact cash flow for property investors, particularly those with negatively geared properties. Without the ability to offset rental losses against other income, investors may face higher tax bills and need to reassess their investment strategies.

Portfolio Management

The choice between portfolio and property-by-property treatment requires careful consideration:

Portfolio benefits:

• Simplified administration
• Ability to offset losses across properties
• Potential for eventual offset against other income

Property-by-property benefits:

• More precise tracking of individual property performance
• Clearer path to using deductions when specific properties are sold
• Better suited for investors with mixed investment strategies

Timing of Acquisitions and Disposals

The timing of property purchases and sales becomes more critical under ring-fencing rules. Investors need to consider:

• Whether properties will be taxable on sale
• The impact on unused deductions
• Portfolio composition and performance balance

Compliance and Administration

Record Keeping

Ring-fencing rules increase the importance of maintaining detailed, property-specific records. Investors must track:

• Income and expenses for each property
• Carried-forward losses
• Portfolio composition and changes
• Election choices and their tax implications

Professional Advice

Given the complexity of these rules and their interaction with other recent changes to property taxation, professional tax advice becomes increasingly valuable for property investors. This is particularly important when:

• Considering new property acquisitions
• Planning property disposals
• Arranging or refinancing property investments
• Structuring multi-property portfolios

Looking Forward

The ring-fencing rules represent just one element of broader changes to property taxation in New Zealand. These rules interact with other recent introductions, such as interest limitation rules that restrict deductions for mortgage interest on residential investment properties.

For property investors, success in this new environment requires:

• Comprehensive understanding of the rules and their implications
• Careful strategic planning around portfolio composition and timing
• Robust record-keeping and compliance systems
• Regular professional advice to navigate the complex and evolving regulatory landscape

The ring-fencing rules fundamentally change the economics of rental property investment in New Zealand. While they don’t prevent property investment, they do require investors to approach their investments with different expectations around tax benefits and cash flow impacts. Understanding these rules and planning accordingly is essential for anyone involved in the residential rental property market.

Whether you’re a seasoned property investor or considering your first rental property purchase, the ring-fencing rules will likely impact your investment returns and tax position. Taking the time to understand these rules and seek appropriate professional advice will help ensure your property investment strategy remains viable and compliant in the current tax environment.

Contact us today to discuss how we can help you navigate Ring-Fencing Rules

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