Chapter 2 – Deductibility of holding costs for private use periods
- Option 1: Apportionment
- Option 2: Allow all deductions
- Option 3: Deny all deductions
- Officials’ views
- Holding costs for different entities
2.1 Holding costs are generally deductible where land is used to earn taxable income. However, the private limitation denies a deduction for an amount of expenditure or loss to the extent it is of a private or domestic nature.
2.2 The level of deduction that is allowed for holding costs in situations where there is some private use of the property and the sale of the property is taxed is currently unclear.
2.3 Three options for deductibility are discussed below.
Option 1: Apportionment
2.4 Holding costs relate both to any current year use of the land and to any eventual gain on sale. The holding costs could therefore be apportioned between the private-use benefit and the taxable gain on sale. For example, if a person received $100 worth of private benefits from their private use of the land, and a $100 taxable gain on sale, they would be entitled to a deduction of fifty percent of the holding costs on the basis that only fifty percent of the total benefit is taxable.
2.5 Arguably, apportioning holding costs between private and taxable benefits would be the most accurate approach. However, correct apportionment requires both the benefit of the current year use, and the income derived on sale, to be measurable. Measuring the value of the private benefit is likely to be difficult, and the taxable gains are not known until the property is sold. Therefore, accurate apportionment is likely to be complex. Simplified apportionment approaches could be developed (for example, fifty percent of holding costs are deductible for private use periods regardless of the values of the private and taxable benefits), however, these would be arbitrary and would compromise accuracy.
2.6 An apportionment approach would also be inconsistent with other areas of New Zealand’s tax law where no apportionment for holding costs is required. For example, holding costs for rental properties held on capital account are fully deductible (subject to the new rental ring-fencing rules) even though those holding costs also relate to a non-taxable capital gain. Requiring apportionment in those circumstances would likely improve neutrality and fairness. However, it would be a significant change to the existing tax law and may increase complexity.
Option 2: Allow all deductions
2.7 The second option would be to allow deductions for holding costs in full, despite any private use, on the basis that the holding costs are all incurred in deriving the taxable income from sale. This bases deductibility on whether there is a taxable use of the land, regardless of whether there is a non-taxable or private use of the land.
2.8 Allowing deductions in full for holding costs during periods of private use would result in deductions being allowed for private expenditure. This is inconsistent with an important principle of New Zealand’s tax framework.
Option 3: Deny all deductions
2.9 The final option would be to deny all deductions for holding costs for periods in which the land is used privately. For example, no deductions for holding costs would be allowed for a bach that is taxed on sale under the bright-line test but was used one hundred percent privately while it was held.
2.10 This option bases deductibility on the current year use of the land. If the current year use of land is income-earning, for example a rental property, deductions for holding costs would be allowed. Conversely, deductions would be denied if the current year use of land is private. Where current year use of land involves a mixture of both income-earning and private use, deductions would only be denied for the days where the land is used privately.
2.11 Consistent with the current rules for rental properties where deductions are allowed in full despite the gain on sale not being taxed, the taxable gain on sale would be ignored for determining the deductibility of holding costs.
2.12 This option is consistent with keeping private expenditure out of the tax base. This option is also consistent with the Tax Working Group’s capital gains tax design recommendations, where it was recommended that no deductions should be allowed for holding costs where land is used privately.[2] It may also reduce compliance costs for bright-line taxpayers who would otherwise have to find prior year evidence to support deductions at the time of sale.
2.13 This option may be seen as unfair as it does not recognise the fact that the holding costs do relate in part to the taxable gain on sale. Furthermore, in situations where a person regularly purchases properties to renovate and sell, and lives in the properties while they own them, this approach would deny all holding costs (including repairs and maintenance expenditure) for the period in which they live in the properties.
Officials’ views
2.14 An approach which apportions holding costs between the current year use and the gain on sale would arguably be the most accurate option. However, as noted, an apportionment approach would likely be complex, or sacrifice accuracy in order to reduce complexity.
2.15 Furthermore, an apportionment approach is inconsistent with other parts of the tax system where apportionment is not required. As noted, requiring apportionment in cases where the current year use is income-earning and the gain on sale is non-taxable would be a significant change to the existing tax law and is likely to increase complexity. Officials therefore do not propose changing the existing tax law to require apportionment in these circumstances.
2.16 In the absence of changing existing tax law to require apportionment when the gain on sale is non-taxable and the current year use is income earning, officials’ view is that an apportionment approach is not appropriate for situations where the current year use is private and the gain on sale is taxable.
2.17 Instead, officials consider the best option is to deny deductions for holding costs for periods of private use.
Holding costs for different entities
2.18 For simplicity, the discussion has focused on land in individual ownership. However, land can be owned by a number of different entity types. Officials are aware that having different rules applying to different entity types might incentivise owners to move land into entities where the rules are perceived to be better. This is not considered to be a good outcome.
2.19 Officials consider the above proposals should apply in the same way for individuals, partnership, trusts, and look-through companies. For all of those entities, expenditure is only deductible where there is sufficient connection between the expenditure and income, or between expenditure and a business carried on for the purpose of deriving income. To the extent that land is used privately, holding costs will not be connected to any income. Therefore, the proposals to deny deductions (wholly or in part) for private use should affect individuals, partnerships, trusts, and look-through companies in the same way.
2.20 For most expenditure, the same principle applies to companies. If land owned by a company is used privately by its shareholders, and the company is deriving no income from that use, most holding costs will not be deductible to the extent of the private use. However, companies are generally entitled to full interest deductions whether or not the interest is connected to income. Therefore, taxpayers could choose to use a company to hold private land in order to obtain full interest deductibility.
2.21 While officials are aware of this potential inequity between companies and other structures it is not proposed that the rules should be changed for companies. While companies are allowed full interest deductions, private use of land by shareholders will either require the shareholders to pay full market rent to the company (which is taxable to the company and non-deductible to the shareholders) or would give rise to taxable dividend income for the shareholders. Private use of land by employees of the company will give rise to a benefit to the employee which is either taxable as employment income, or subject to FBT.
2.22 On that basis, officials consider that there are already rules that disincentivise company ownership of privately used land. However, officials are interested in whether there are other views on this issue.
2.23 Even if no changes are made to the rules for interest deductibility for companies, officials will monitor this area and consider changing the rules should taxpayers start to use this structure more.
[2] See the Tax Working Group’s Final Report, Vol II, Chapter 4, paragraph 8.