Transfer of residential rental properties in relationship split — how do interest limitation rules apply?

QUESTION:
A husband and wife partnership owned several rental properties. The partnership had loans over the rental properties taken out before 27 March 2021.

The husband and wife finalised the splitting of their assets in August 2021. Part of the divorce settlement was that the husband took over 2 of the rental properties. He had to take out a loan in his own name to repay the joint loan.

Is the husband able to claim the interest on the loan that he took out in August 2021 to repay the existing loan, drawn down prior to 27 March 2021, that was in joint names?

ANSWER:
A partnership is tax transparent. Therefore, the husband is treated as owning half the residential properties and being liable for half the partnership's loans for tax purposes.

While the interest limitation rules now deny interest deductions incurred in respect of “disallowed residential property” purchased on or after 27 March 2021, interest from loans drawn down before that date (“grandparented transitional loans”) is being progressively phased out over a period of 4 years, ending on 31 March 2025. See s DH 8 of the Income Tax Act 2007.

Husband’s half interest in the properties

A grandparented transitional loan includes a loan taken out for refinancing a pre-27 March 2021 loan (ie where a subsequent loan is taken out to pay off the original loan). See s DH 5(5)(e). Therefore, with regard to the husband’s deemed half interest in the partnership properties and loans, 50% of the new loan drawn down is refinancing 50% of the partnership loan he was treated as already having. The interest in relation to that portion of the loan will therefore still be deductible (but subject to the phase-out) on the basis it is simply a refinancing.

Transfer of wife's half interest in the properties

The transfer of the wife's 50% of the properties to the husband (assuming the properties were transferred under a settlement of relationship property as defined in s FB 1B) will be subject to rollover relief. See s DH 5(5)(d). Where disallowed residential property is transferred under a settlement of relationship property entered into between 27 March 2021 and 31 March 2025, any loan drawn down or taken over by the transferee (ie the husband) is treated as a grandparented transitional loan.

Interest on the loan for the residential rental properties will, therefore, continue to be deductible under the interest phase-out to the extent that the loan is equal to or less than the amount of the partnership's loan when the property was transferred.

In summary, the husband's new loan to refinance the partnership loans, to the extent it does not exceed the partnership loan, should be a grandparented transitional loan.

​References:
Income Tax Act 2007, ss DH 1, DH 2, DH 5, DH 7, DH 8, FB 1B, FB 3A.

This article has been reproduced from CCH / TEO Q & A Service:

In recent years the Government has made various changes to the tax law around land sales and purchases and one needs to be very careful about any possible tax consequences that may be associated with any purchases or sales of property / land, be it regarding GST or income tax.
 
Below is a perfect example of how you can be caught for tax unwittingly and with a seemingly innocuous transaction:
 
Below reproduced from CCH / TEO Q & A Service:

QUESTION:
A couple purchased a residential property in January 2021 and are putting the home on the market 18 months or so later.

The couple have separated and are living in separate homes (with one living in the property that is being put on the market and using it as their main family home). The children are adults and do not live with the parents.

No improvements have been made to the home, there was no intention to sell when purchased, no subdivision has taken place and the vendors are not builders or developers.

Is the sale of this house, which is the main family home, subject to the bright-line test?
ANSWER:
Because the property was acquired in January 2021, the sale will be subject to the 5-year bright-line test in s CZ 39 and the main home exclusion in s CZ 40. The main home exclusion states that the bright-line test does not apply to a person who disposes of residential land if, for most of the bright-line period, the land has been used predominantly for a dwelling that was the bright-line grandparented home for the person.

Bright-line grandparented home means, for a person, the one dwelling:

• that is mainly used as a residence by the person (a home), and
• with which the person has the greatest connection if they have more than one home.

The owner that has remained living in the property will likely qualify for the main home exclusion, assuming the property has been their main home for most of the time since acquisition in January 2021 up until the time they enter into an agreement to sell the property.

For the other owner who has moved out of the property, the main home exclusion will apply only if the period for which the property was their main home (ie, from January 2021 until they moved out of the property) is longer than the period that it has not been their main home (ie, from the date they moved out of the property to the date they enter an agreement to sell the property). If the other owner has lived elsewhere for longer than living in the property, they will be subject to tax on the sale of their half interest in the property.

References:

Income Tax Act 2007, ss CZ 39, CZ 40, YA 1 ("bright-line grandparented home").

​From the 1st of April 2021 the top marginal tax rate for individuals is being raised to 39% on income earned over $180,000. With this change there are several things to consider from a tax perspective as company and trust tax rates remain at 28% and 33% respectively. It may seem prudent to setup a trust or leave more profit in your company as a means to lower your overall tax bill. However, the IRD has signaled they will be closely monitoring the establishment of new trusts, movement of funds, and other related activity through the use of increased disclosure requirements on taxpayers and the increased capability of their IT system to carry out analytics to identify behaviour changes. Minister of Revenue, Hon David Parker has stated “If that behaviour becomes apparent, then we’ll move to increase the trust rate to avoid that being used as an avoidance loophole”.
 
A “tax avoidance arrangement” is an arrangement that has tax avoidance as one of its purposes or effects, the tax effect must be more than merely incidental. If a taxpayer is found to have entered into a tax avoidance arrangement, they are subject to penalties of up to 100% of the shortfall. It is imperative that there are commercial reasons outside of tax minimisation for restructuring involving trusts or companies, and transactions related to them as IRD scrutiny will be particularly high in these areas.

​Bright- Lines
In March 2021 the Government announced it would be extending Bright-line test for residential property purchased after the 27th of March 2021 from 5 to 10 years. This means any residential property purchased after that date and sold within 10 years will be subject to tax on any capital gain over that period.
New builds which include dwelling which have their Code of Compliance Certificate (CCC) issued after 27 March 2020 and conversions of commercial property, hotels and motels will still be subject to 5 years bright-line test.
The main home exemption still applies however is changed for property captured under the new rules. Under the old rules the exclusion applied as long as the property was used as the owner’s main home for more than 50% of the bright-line period. Under 10 year bright-line rules the exemption will instead only apply for the time the property is used as the owner’s main home. A “Buffer Rule” has also been introduced where the property is not used as the main home for continuous periods not exceeding 365 days, those days are counted as day where the property has been used as a main home, provide the dwelling is used as the main home at the beginning or end (or both) of that period. There is a proposed amendment which would extend this in the case where a person making reasonable effort to construct a dwelling intended for use as their main home. For the main home exemption to apply, at some point, the home must have been lived in. “intention” to live in is not good enough on its own.
Certain transfer to associated entities and changes from tenants in common to joint tenants and vice versa will not reset the bright-line date.
Interest Limitation
The Government has also made changes to remove a “loophole” for the deductibility of interest on residential properties acquired on or after the 27th of March 2021, this change is being phased in over a period of 5 years with the portion deductible interest decreasing yearly until 2025 after which no interest deduction will be allowed.

• Residential properties acquired on or after 27 March 2021

• No interest deduction from 1 October 2021

• Residential properties acquired before 27 March 2021

• 1 October 2021 to 31 March 2023                      75%
• 1 April 2023 to 31 March 2024                            50%
• 1 April 2024 to 31 March 2025                            25%
  
• 1 April 2025 on                                                     0%                                            

Loans is foreign currencies will become non-deductible from 1 October 2021 regardless of purchase date.
These changes will not apply to dealers, developers and subdivides, and builders subject to tax under CB7. New builds which are dwelling which have CCC issued after 27 March 2020 will also have an exemption which lasts 20 years from the issue of the CCC.
Interest which has been denied under the Interest Limitation can be added to the cost of the asset should the sale be taxable under the bright-lines rules, reducing any capital gain.
This material has been prepared for informational purpose only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Please contact us for advice on your specific circumstances.  

On top of the much publicised re-write of the Trust Act, Inland Revenue (IRD) has issued a recent classification in relation to whom is classified as "settlor" of a trust. Section HC 27 of the Income tax act 2007 states a settlor is a person who "transfers value to the trust, for the benefit of the trust or on terms of the trust".

However, IRD have recently provided definite clarification on this matter. A legislative amendment to HC 27 has been made and a "Commissioner's Operational Position" has been issued. 

According to s HC 27(2), a beneficiary who has taken possession and enters into a contract to lend money back to the trust may be deemed a settlor if he or she:

• Contracts to be paid nil or below market-rate interest, or
• Contracts to receive interest but does not make demand for such interest or defers demand, or
• Does not demand repayment of capital.

However, a beneficiary will not become settlor if either:

• The amount owing to them from the trust at the end of the income year is $25,000 or less; or
• The trust pays interest to the beneficiary at a rate equal to or greater than the prescribed IRD interest rate. 

This new rule becomes effective from 1 April 2020 and does not have retrospective effect.

If a person becomes a settlor it can lead to unintended tax consequence. The tax position of a trust is based on the tax residency of the settlor.

The Act received royal assent on 31 July 2019. The new Act will come into force on 30 January 2021, the new Act will evolve more in favour of the beneficiary.

The new Act divides trustees duties into two types:

• Mandatory duties that you cannot contract out of;
• Default duties that apply unless stated otherwise in the trust deed

 ​Mandatory Duties of Trustees

• Understand the terms of the trust deed 
• Act in the best interests of beneficiaries
• Act honestly and in good faith
• Exercise powers for proper purpose
• Account to the beneficiaries
• Cannot contract out of personal liability as a trustee

Default Duties of Trustees

• Impartiality - treat all beneficiaries of the same class even-handedly 
• Unanimity of Trustees 
• Not to profit from the Trust (trustees are to hold the assets on trust for the benefit of the beneficiaries, not for themselves)
• Invest prudently
• Retain core documents
• Act for no reward - If you want to pay your trustees, your trust deed to specifically state this, otherwise they cannot be remunerated. 

Importance of Record-Keeping

• If a beneficiary challenges something the trustees have done, the records will be needed to defend it
• Retain documents for the life of the trust 
• Trustee meetings is crucial - so you can show you have carried out your duties as a trustee properly

Investing Prudently

• section 30 of the new Act 
• very high onus on trustees to invest prudently (i.e. having a wide investment portfolio) as if investing property for someone else. If a lawyer or accountant, the trustee must act as if they are investment advisors.
• Example: Allowing settlors to live in trust property rent free is not a prudent investment 
• You can contract out of this in the trust deed

Rights of Beneficiaries 

• Obligation on trustees to let beneficiaries know they are beneficiaries
• You can contract out of this but need specific wording in the trust deed.
• Beneficiaries need to know who the trustees are so they can hold them to account and obtain information from them 
• Important to consider the class of beneficiaries and narrow this if need be
• I.e. distant family members as beneficiaries who you do not want obtaining information about the trust.

What Information Can a Beneficiary Get?

• Copy of trust deed and any amendments (i.e. deeds of variation)
• Assets and liabilities 
• Income and expenditure (trust financials)
• Information regarding the administration of the trust 
• But not trustee reasons
• Best not to put trustees' reasons for a decision in writing as it could be challenged by a beneficiary 

What Do Trustees Need to Consider?

• Wishes of the settlors
• effect of giving information
• Practicality of giving information
• Other relevant considerations
• Make it clear in the trust deed what information you are prepared to provide to beneficiaries and what you are not.

The Life of Trust 
Trust could last for a maximum of 80 years previously, but now the trust can last for 125 years.

Incapacity and Trusts 
​The new Act makes it compulsory to remove incapacitated trustees and enduring powers of attorney are not relevant to trusts.

The new rules mean greater transparency of trustee activity and increased trust compliance requirements because trustee duties are now formalised in legislation. 

The Taxation (Annual Rates for 2018-19, Modernising tax Administration, and Remedial Matters) Bill, was introduced into Parliament on 28 June 2018. The revenue system will be modernised to make the tax easier for individual, and the rules and processes will be simpler. 

New year - end tax obligations for individuals
The Bill proposes a number of amendments for the end of year income tax obligations of individuals and some of the processes that will be undertaken by Inland Revenue (IR). In summary, the proposed changes are:

• IR will make a pre-populated account available to each individual containing the income information that IR holds for the individual.
• IR will calculate the refund of tax to pay without the individual needing to provide any additional information. 
• Individuals will be required to provide any income information other than reportable income to IR subject to some de minimis rules.
• Individuals will be able to provide other relevant information such as deductible expenses and tax credit information to IR.
• Individuals will be required to provide or correct reportable income where they know or have reason to know that the reportable income information provided to IR is incorrect.
• And individual's tax assessment will occur when they have confirmed the tax information is complete, when IR is reasonably satisfied that the information is complete, or when IR is not satisfied that the information is complete and issues a default assessment.
• Individuals and IR will be able to make corrections to the information held where they become aware that it is incorrect or incomplete and there will be error correction processes for adjustments made before and after an assessment has occurred.
• The end of year income tax process will replace the current personal tax summary and will replace the IR3 tax return processes over time as the paper IR 3 is phased out.

The end of year income tax process changes will mean that IR provides as much information about an individual's income and tax credits as it can to form a basis for the calculation of the individual's tax position (refund or tax to pay).

Individuals will be required to provide information on their other income (income other than their reportable income) and will be able to provide information on deductions and tax credits. This additional information will be added to the individual's pre-populated account (now their adjusted account) and will become the individual's self-assessment. 

Changes for refunds and amounts of tax to pay 
The Bill also proposed a number of amendments to improve the process for issuing refunds and advising individuals that they have tax to pay or are due a refund. In summary, the proposed changes are:

• IR will calculate whether people who are not expected to be required to provide information to IR are entitled to a refund or have tax to pay
• Refunds will be paid out without individuals having to request them.
• IR will issue income tax refunds by direct credit, unless that will result in undue hardship or is not practicable.
• Amounts of tax to pay arising from withholding tax regimes where tax was withheld in accordance with the PAYE rules, or where tax was withheld at the rate corresponding to the individual's marginal tax rate, will not have to be paid.
• Amounts of tax to pay arsing from a withholding tax regime where less than $200 of income was taxed incorrectly will not have to be paid.

All of the proposed amendments are intended to come into force 1 April 2019 and to apply for the tax year-end processes for the tax year ended 31 March 2019. 

The release of an official's issues - paper entitled "Ring-fencing rental losses" was issued in march 2018. and introduced into Parliament on 5 December 2018 as a part of the taxation (Annual Rates for 2019-20, GST Offshore Supplier Registration, and remedial Matters) Bill. According to this proposal, speculators and investors will no longer be able to offset tax losses from the residential properties against their other income but can be used in future years to reduce the tax when the properties make profits or the sale of land.

Property subject to the rules (ss DB 18 AC to DB 18 AK)
The provisions of "Ring-fencing rental losses" will apply to "residential rental property", which is defined as "residential land'. However, the following are excluded from "residential rental property".

• a person's main home
• land that is subject to the mixed-used assets rules
• land that is owned by a widely-held company
• land that is identified to Inland Revenue (IR) as being taxable on sale (see below), and 
• accommodation provided to employees or other workers where it is necessary to provide the accommodation due to the nature or remoteness of the business carried on.  

Land taxable on sale
The proposed rules will not apply if the land is identified to IR as being taxable on sale. This would include land held in dealing, development, subdivision, and building businesses, and land that was bought with the intention of resale. 

the exclusion for land that will be taxable on sale will be available if either:

• the taxpayer is notifying the Commissioner of their rental income and expenditure for that property on a property-by-property basis, or
• they are notifying the Commissioner of their rental income and expenditure on a portfolio basis and all of the properties within the portfolio are on revenue account

Portfolio basis by default with property-by-property application by election
The proposed default position is that the loss ring-fencing rules will apply on a portfolio basis, which means the investors are able to offset deductions for one rental property against income from other rental properties.

Use of ring-fenced deductions

Portfolio basis
if the portfolio basis is used, ring-fenced residential property deductions will be able to be offset against: 

• residential rental income from future years (from any property)
• income on the taxable sale of any residential land, to the extent of reducing the taxable gain on the sale to nil. 

property-by-property basis
If the property-by -property basis is used, ring-fenced deductions relating to the property will be able to be offset against:

• residential rental income from future years (from that property)
• income on the taxable sale of that property, to the extent of reducing the taxable gain on the sale to nil. 

Unused deductions
Generally, any remaining unused deductions will continue to be ring-fenced and carried forward to be used against any future residential rental income or income from other residential land sales
However, it is proposed that ring-fenced deductions will be released in certain situations. 

Transfer between companies in wholly-owned group
Ring-fenced deductions are allowed to be transferred between companies in a wholly-owned group according to proposed s DB 18AI. And any remaining deductions will be carried forward and will remain ring-fenced. The transferred deductions will remain ring-fenced until offset against residential rental income or residential land sale income. 

Interposed entities -residential land-rich entities
The interposed entity rules will apply for interest on borrowings to acquire an interest in an entity if, for a particular income year, the entity is a "residential land -rich entity" - which will be where over 50% of the entity's assets are residential properties. 

where the land - rich threshold is met, part or all of the interest on the borrowings will be treated as residential rental property expenditure, and deductions will be ring-fenced. 

The proposed new rules are intended to apply from 1 April 2019 for the 19/20 and later income years. They will not apply to a deduction a person is allowed for a prior income year.

​Recent changes to the Taxation Act 2017 mean that owners of closely held companies (five or less shareholders) now have the option to apportion expenditure on motor vehicles that are provided to shareholder employees between business and personal by using actual records, a percentage based on a logbook or in accordance with the IRD’s mileage rates. This avoids the need to pay FBT on these vehicles.
 
This election may only be made when the vehicle is first acquired or first used for business purposes from the start of the 2017/2018 tax year or later. This apportionment rule only applies to shareholder employee vehicles, therefore FBT will still apply to motor vehicles which are used by employees who are not shareholders. 

The government has announced extending the bright-line test on residential property from two to five years. This change will come into effect once the Bill receives the Royal assent expected to be sometime in March 2018. Residential properties purchased before the new Bill is enacted will still be subject to the two year bright-line test.

The effect of the change is that gains from the disposal of residential land acquired and disposed of within five years will be taxable, subject to some exceptions.

The bright-line test only applies to residential land. This includes land that has a dwelling on it, land where the owner has an arrangement to build a dwelling on it, and bare land that could have a dwelling erected on it under the relevant district plan. It does not include commercial premises or farmland.

​There are exclusions to the bright-line test for a person’s main home, relationship property in certain circumstances and inheritances. A person may only have one main home and a person may not use the exclusion if they are deemed to habitually sell their main home.

The purpose of these changes is to ensure speculators pay tax on gains from property speculation as well as improve affordability for owner-occupiers by reducing demand from speculators.