New Zealand landlords 'face the most severe tax regime of any developed country'

New Zealand landlords could soon be facing the most severe tax regime in any developed country, according to research by Macquarie's equities research team, as the Government considers removing depreciation entitlements from an array of building fixtures and fittings.

The research, contained in a report by Macquarie analyst Stephen Ridgewell entitled NZ property sector Government twists the knife, looks at the potential outcomes from a review by the Inland Revenue Department  of the depreciation classification of buildings' fixtures and fittings such as carpets, curtains, electrical wiring, plumbing and air conditioning units. The review was announced by Finance Minister Bill English in his Budget speech.

English said the treatment of commercial building fitout would be reviewed, and if necessary amended before April 1, 2011, to clarify the law on the split between buildings which will not be depreciable and separate assets which will continue to be depreciable. This means assets, previously considered separate to the building they're in or on, could be considered part of the building itself.

“Taxpayers will, of course, still be able to claim deductions for repairs and maintenance,” English added.

The review of commercial property follows one done on residential property in April. It concluded that most assets previously considered fixtures and fittings should now be considered part of the building structure for residential properties.

So, in a worst case scenario for commercial landlords including sharemarket listed property trusts such as Kiwi Income Property Trust, Goodman Property Trust and ING Medical Properties Trust, Ridgewell says three quarters of existing fixture and fittings depreciation could be lost, with the IRD not permitting landlords to deduct the actual cost of replacing fixtures and fittings.

He notes fixtures and fittings account for between 34% and 70% of the total depreciation deductions claimed by the listed property trusts, so between 20% and 50% of total current depreciation claims could be axed post the review.

"Effective tax rates (for listed property trusts) could jump 6.5% and earnings could fall 7.4%," says Ridgewell.

More broadly he maintains New Zealand landlords could soon find themselves facing the most severe tax regime in any developed country.

“Only three countries, the UK, Ireland and Singapore – currently do not permit depreciation deductions on building structures.”

“As far as we are aware, no country has both denied depreciation deductions on building structures and denied depreciation deductions on a significant portion of what is normally considered fixtures and fittings,” Ridgewell says.

This, he says, means the quality of building space will be less attractive for tenants although the same rent will be expected. And ultimately some investment could be lost to other countries, notably Australia where depreciation deductions are still allowed for both buildings and fitout.

Another issue Ridgewell raises is that changes could be complex to administer and encourage landlords to restructure leases. Because although landlords won’t be allowed to depreciate fitout, tenants or third parties might be able to.

“If so, this will encourage both landlords and tenants to restructure their activities to be tax efficient and the IRD will be busy adjudicating what it considers to be a legitimate commercial arrangement and what is tax avoidance. Alternatively, the IRD may avoid such complications by ruling that such items cannot be depreciated , regardless of ownership."

He does acknowledge there is significant uncertainty over where IRD will draw the line, with a range of possible outcomes possible from the tax review. The results are expected to be released in September.

Ridgewell outlines three key issues:

1) Where IRD draws the line on what is designed as fitout. Will lifts, wiring, ceilings and air conditioners remain classified as fixtures and fittings?

2) Whether the IRD grandfathers existing deductions, IE makes the new rules only applicable to new investments.

3) Whether IRD permits the expense incurred in replacing fitout to be deductible as repairs and maintenance.

He estimates as much as 50% to 75% of assets currently classified as fixtures and fittings could be reclassified as buildings and therefore not be depreciable.

Although the depreciation provisions of the Income Tax Act do apply to buildings, Ridgewell points out there's no definition of 'building' in the Act.

Until recently IRD's distinction between buildings on the one hand and fixtures and fittings on the other, has only determined the time period over which the asset has been depreciable and whether loss on sale can be claimed. However, the Government's May 20 Budget has changed this with depreciation no longer permitted on buildings from April 2011.

"The definition of 'building' has therefore become of much greater importance to landlords," says Ridgewell.

Using a three step process in the residential rental property review the IRD decided most assets previously considered to be fixtures and fittings should now be considered part of the building structure for residential properties.

The process includes:

1) Determining whether the asset is physically attached to the building in some way. If not it can be depreciated as a separate asset.

2) If an asset is attached to the building, it must also be integral so that the building would not be complete without it. If the asset is integral it cannot be depreciated as a separate asset.

3) If an asset is not integral, determine whether the asset is attached in such a way that it is considered to be part of the fabric of the building.

Assets previously assessed as having a useful economic life of less than 15 years, such as carpets and curtains, have generally retained their classification as separate assets and can therefore still be depreciated.

But most assets previously assessed as having useful economic lives longer than 20 years, including lifts, electrical wiring, plumbing, ceiling grids and tiles, have been reclassified as being part of the building and from next April won’t be depreciable. 

Ridgewell notes that air conditioning systems seem to be grey area. Although systems that are considered to be in use for 24 hours have retained their status as separate assets, air conditioning units not used so intensively have been reclassified as part of the building.

The Macquarie report argues IRD's possible new depreciation rules won't reflect economic reality with punitive impacts on landlords.

"In re-classifying assets such as air conditioning systems to be part of the building rather than separate assets, the IRD is in effect arguing those assets have a useful economic life of 50 years or more," says Ridgewell.

"This is contrary to the IRD's previous views of their economic lives (generally 20 to 25 years) and moreover, far removed from economic reality (which is 15 to 25 years)."

Furthermore he notes air conditioning units generally last longer in residential homes than commercial buildings.

Thus misalignment of depreciation rules to economic reality will have unintended but predictable consequences including:

- Declining quality of building stock.

- Higher rents in the long-term.

-Loss of investment.

- Restructuring of leases so that tenants or third parties maybe able to do fitouts on behalf of landlords.

“We suggest if that if the potential tax changes are adopted property values will fall, and that the decline in development land values could be particularly sharp,” says Ridgewell.

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